CHAPTER 1: THE INVESTMENT ENVIRONMENT
CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. While it is ultimately true that real assets determine the material well-being of an
economy, financial innovation in the form of bundling and unbundling securities
2. Securitization requires access to a large number of potential investors. To attract
these investors, the capital market needs:
1. a safe system of business laws and low probability of confiscatory
taxation/regulation;
These characteristics are found in (indeed make for) a well-developed financial
market.
3. Securitization leads to disintermediation; that is, securitization provides a means
for market participants to bypass intermediaries. For example, mortgage-backed
securities channel funds to the housing market without requiring that banks or
4. The existence of efficient capital markets and the liquid trading of financial assets
make it easy for large firms to raise the capital needed to finance their investments
in real assets. If Ford, for example, could not issue stocks or bonds to the general
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5. Even if the firm does not need to issue stock in any particular year, the stock market
is still important to the financial manager. The stock price provides important
In addition, shares that can be traded in the secondary market are more attractive to
Remember that stock exchanges like those in New York, London, and Paris are the
6. a. No. The increase in price did not add to the productive capacity of the
economy.
7. a. The bank loan is a financial liability for Lanni, and a financial asset for the bank.
b. Lanni transfers financial assets (cash) to the software developers. In return,
c. Lanni exchanges the real asset (the software) for a financial asset, which is 2,500
d. By selling its shares in Microsoft, Lanni exchanges one financial asset (2,500
shares of stock) for another ($125,000 in cash). Lanni uses the financial asset of
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8. a.
Assets Liabilities &
Shareholders’ Equity
Cash
$ 70,000
Bank loan
$ 50,000
Computers 30,000 Shareholders’ equity 50,000
Total
$100,000
Total
$100,000
b.
Assets Liabilities &
Shareholders’ Equity
*Valued at cost
Ratio of real assets to total assets = $100,000/$100,000 = 1.0
c.
Assets Liabilities &
Shareholders’ Equity
Conclusion: when the firm starts up and raises working capital, it is characterized by
c. The difference should be expected primarily because the bulk of the
business of financial institutions is to make loans and the bulk of the
10. a. Primary-market transaction in which gold certificates are being offered to
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b. The certificates are derivative assets because they represent an investment in
11. a. A fixed salary means that compensation is (at least in the short run) independent
of the firm’s success. This salary structure does not tie the manager’s immediate
b. A salary that is paid in the form of stock in the firm means that the manager earns
the most when the shareholders’ wealth is maximized. Five years of vesting helps
align the interests of the employee with the long-term performance of the firm. This
c. A profit-linked salary creates great incentives for managers to contribute to the
firm’s success. However, a manager whose salary is tied to short-term profits will be
12. Even if an individual shareholder could monitor and improve managers’ performance
and thereby increase the value of the firm, the payoff would be small, since the
In contrast, a creditor, such as a bank, that has a multimillion-dollar loan outstanding
13. Mutual funds accept funds from small investors and invest, on behalf of these
investors, in the domestic and international securities markets.
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Pension funds accept funds and then invest in a wide range of financial securities, on
Venture capital firms pool the funds of private investors and invest in start-up firms.
14. Treasury bills serve a purpose for investors who prefer a low-risk investment.
15. With a top-down investing style, you focus on asset allocation or the broad
composition of the entire portfolio, which is the major determinant of overall
With a bottom-up investing style, you try to benefit from identifying undervalued
securities. The disadvantage is that investors might tend to overlook the overall
16. You should be skeptical. If the author actually knows how to achieve such returns, one
must question why the author would then be so ready to sell the secret to others.
17. Financial assets provide for a means to acquire real assets as well as an expansion
18. Allowing traders to share in the profits increases the traders’ willingness to
assume risk. Traders will share in the upside potential directly in the form of
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19. Answers may vary, however, students should touch on the following: increased
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