Chapter 01 – Investments: Background and Issues
CHAPTER 01
INVESTMENTS: BACKGROUND AND ISSUES
1. Equity is a lower-priority claim and represents an ownership share in a corporation,
whereas fixed-income (debt) security is a higher-priority claim but does not have an
2. The primary asset has a claim on the real assets of a firm, whereas a derivative asset
provides a payoff that depends on the prices of a primary asset but does not include the
claim on the real assets.
3. Asset allocation is the allocation of an investment portfolio across broad asset classes.
Security selection is the choice of specific securities within each asset class.
6. Investment bankers are firms specializing in the sale of new securities to the public,
typically by underwriting the issue. Commercial banks accept deposits and lend the
7. Financial And Real Assets
a. Toyota creates a real asset—the factory. The loan is a financial asset that is created
8. Real Estate as a Real Asset
a. No. The real estate in existence has not changed, only the perception of its value has.
Chapter 01 – Investments: Background and Issues
9. Real and Financial Assets
a. The bank loan is a financial liability for Lanni. Lanni’s $50,000 IOU is the bank’s
financial asset. The cash Lanni receives is a financial asset. The new financial asset
created is Lanni’s promissory note held by the bank.
10. a.
Cash $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
Assets
Liabilities &
Shareholders’ Equity
000,100$
b.
Software product* $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
*Value at cost
Assets
Liabilities &
Shareholders’ Equity
000,100$
Chapter 01 – Investments: Background and Issues
c.
Microsoft shares (@$70/share)
$140,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 120,000
Total $170,000 Total $170,000
Assets
000,155$
Conclusion: When the firm starts up and raises working capital, it will be characterized
by a low ratio of real to total assets. When it is in full production, it will have a high
11. Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act
proposed several mechanisms to mitigate systemic risk. The act attempts to limit the
risky activities in which the banks can engage and calls for stricter rules for bank capital,
liquidity, and risk management practices, especially as banks become larger and their
12. a. For commercial banks, the ratio is:
$125.2
$16,780.2
= 0.0075
$22,535
13. National wealth is a measurement of the real assets used to produce GDP in the
economy. Financial assets are claims on those assets held by individuals.
Chapter 01 – Investments: Background and Issues
Financial assets owned by households represent their claims on the real assets of the
14. Compensation and Agency Problems
a. A fixed salary means compensation is (at least in the short run) independent of
the firm’s success. This salary structure does not tie the manager’s immediate
compensation to the success of the firm, and thus allows the manager to
15. Even if an individual investor has the expertise and capability to monitor and improve
the managers’ performance, the payoffs would not be worth the effort, since his
16. Since the traders benefited from profits but did not get penalized by losses, they were
17. 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 (and make for) a well-developed financial market.
18. Progress in securitization facilitates the shifting of default risk from the intermediates to
the investors of such a security. Since the intermediates no longer bear the default risk,
their role and motivation in assessing and monitoring the quality of the borrowers is
19. (answers will vary)
Mutual funds accept funds from small investors and invest, on behalf of these investors,
20. 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 information
Chapter 01 – Investments: Background and Issues
21. Treasury bills serve a purpose for investors who prefer a low-risk investment. The
lower average rate of return compared to stocks is the price investors pay for
predictability of investment performance and portfolio value.
22. 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.