Principles of Finance 6e Chapter 16
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CHAPTER 16
ANSWERS
16-1 The investment process includes: (a) defining/modifying investment objectives, such as to plan for
retirement, supplement current income, shelter income, or achieve future goals; (b) defining risk
16-2 Monitoring is a very important part of the investment process because the monitoring function
16-3 In their traditional role, stock brokerage firms function as agents of investors, helping them to
16-4 Investors can give brokers a variety of instructions, including to trade at the best price available
when the transaction reaches the market, to limit the price of the transaction, when to begin the
16-5 Stock and bond quotations provide information concerning the previous day’s trades, such as
16-6 The dividend yield is defined as the dividend divided by the current stock price, so it gives the
16-7 The geometric average return takes into consideration compounding while the simple arithmetic
16-8 Market indexes are used (a) to determine how well the financial market as a whole is performing;
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16-9 Different market indexes do not necessarily yield the same results because (a) the measures are
not always constructed the same and (b) the “basket” of investments included in the measures are
16–10 A price-weighted index is computed by summing the price of a single share of each stock and then
16–11 Margin trading magnifies returns because an investor uses borrowed funds that require a fixed
repayment; thus, any returns different from (greater or less than) the repayment of the borrowed
16–12 An investor short sells by borrowing another investor’s stock and then selling the stock in the
market with a promise to replace it at some later date. An investor might short sell either to
16–13 Gains occur when the price of the stock that is shorted declines, because the stock can be
16–14 Because transaction costs reduce the overall return on an investment position, an investor is not
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SOLUTIONS
16-1 P0 = $110
a. P1 = $ 95: Short gain = 200($110 – $ 95) = $3,000
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16-2 $5,400 = 0.6(Total investment)
Total investment = $5,400/0.60 = $9,000
16-3 a. Purchase price = 1,000 shares x $5 = $5,000
Robin’s investment = $5,000 x 0.70 = $3,500
16-4 a. Total dollar return = 250($55 – $50) + 250($1 + $1) = $1,750
16-5 a. Percent of Dollar amount Percent of
Stock stock fund invested in stock total portfolio
Abbott Inc 25.0% $10,000 $10,000/$50,000 = 20%
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16-6 a. Total dollar return = 400($21 – $15) + 400($0.90)
= $2,400 + $360 = $2,760
16-7 a. Total dollar return = 100($27.50 – $25.00) + 100($1.25) = $250 + $125 = $375
$375
$375
of Rate
$25.00
$25.00 500
return
16-8 Year NYSE Return
2009 26.1%
2010 9.8
A
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To illustrate that this is correct, consider what would have happened if you invested $1,000 at
the beginning of 2009. Each year, the value of the investment would be:
Year Investment Value
2009 $1,261.00 = $1,000.00(1.261)
d. Year NYSE Return Investment value
$2,000.00
16-9 a. Portfolio Portfolio S&P 500 S&P 500
Year value return Index return
2008 $17,000.00 903
2009 20,400.00 20.00% 1117 23.70%
b.
Portfolio,A
r
= 90.00%/5 = 18.00%
d. The simple arithmetic average is greater than the geometric average return because it does not
consider compounding. In Chapter 9 we learned that it takes a greater amount or a greater
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e. According to the results in parts (a) through (c), George’s portfolio has performed better than
the market. But, keep in mind that we have not examined the risk of each investment and we
16–10 Shorted 100 shares at P0 = $105
Commissions and other transaction costs are not considered in the following computations.
a. Abby will have to repurchase the stock for $120 per share, so her dollar return would be
100($105 – $120) = -$1,500 (loss).
16-11 a. Stock Return Amount invested Portfolio weight
AT&T 22.5% $ 5,200 34.67%
b. First, we have to compute the values of the stocks at the end of the year:
Beginning Year 1 Ending End-of-year
Stock value return value port. weight
AT&T $ 5,200 22.5% $ 6,370.00 32.85%
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3
1
$128.08
16-14 Total amount of original investment = 300 x $10 = $3,000
a. INV’s value at the beginning of this year = 300 x $30 = $9,000
b. The gain on the short position would equal:
Gain on short position = 100($30 – $20) = $1,000
c. Each year, Abby would have to pay $135 interest (assuming interest is paid each year, hence
not compounded). Thus, at the end of the year, the five-year holding period return would equal:
equity Beginning
interest
year–5
–
value
Beginning
–
value
Ending
=
return period holding year–5
d. The dollar gain on the short position would be $1,000 [(computed in part (b)].
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e. (1) INV’s value at the beginning of the year = $9,000
(2) The loss on the short position would equal:
(3) Including the $135 annual interest, the 5-year holding period return would equal:
$8,325
5($135) – $10) – 300($40
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b. Price Price Price
No. of beg. of MV—beg. end of MV—end end of MV—end
Stock shares Year 1 of Year 1 Year 1 of Year 1 Year 2 of Year 2
Startab 500 $ 75.00 $ 37,500 $ 82.50 $ 41,250 $100.00 $ 50,000
c. The price-weighted index includes one share of each share of stock, thus the stocks with the
16-16 Integrative Problem
a. The client should be asked questions that help determine her current financial position, her
investment objectives, and her risk tolerance level. For example, you could ask whether the
b. The appropriate asset allocation is based on the conditions in the financial markets, both
currently and expected, the investment objectives, and the risk tolerance of the client. If the
c. A stock broker acts as an agent for an investor who wants to trade financial assets. The
d. If the client wants investment information, analysis, and general advice, then she would
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e. The basic types of orders discussed in the text include the following:
1. Market order—an order to execute a transaction at the best price available when the
transaction reaches the market.
f. There are many sources of investment, economic, and other related information, including such
g. The computation for the 1-year holding period return is:
value Beginning
value Beginning – value Ending
=HPY =
Return
Period
Holding
The HPY for each stock is:
$6,000
The HPY for the portfolio is:
9.275% = 0.09275 =
$100,000
$100,000 – $109,275
=
HPYPprtfolio
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Alternatively, we can compute the portfolio HPY using the following equation:
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23.33%– = 0.2333– =
$18,600
$4,340–
=
$18,600
$1,240 – $3,100–
=
$18,600
00)0.10($12,4 – $100)– 310($90
=HPY
(4) A margin call is issued when an investor trades on margin and the price of the stock drops
so that the actual margin is below the maintenance margin. Our client would receive a
margin call when the price of the stock decreases to $61.54.
$61.54 =
0.35) – (1 310
$12,400
=
Margin eMaintenanc
– 1
shares of
Number
borrowed Amount
=
share) (per Price Call Margin
(5) Remember that the amount borrowed is $12,400; so, to have an actual margin of 50
percent, the client must have total equity equal to 50 percent of the total market value of
the stock.
added Funds + $12,400] – [310($61)
= 0.50 =
investment of value Market
equity sInvestor’
=
Margin
Actual
k. (1) The value of the stock that will be short sold is 200 x $35 = $7,000. Therefore, the client will
have to provide a deposit equal to $7,000 x 0.60 = $4,200.
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16-17 Computer-Related Problem
a.
Annual
End of Year Portfolio Value Annual S&P 500 Return Portfolio Value Annual
(George) Return Index (Change) (Daughter) Return
2008 $17,000.00 903 $5,500.00
2009 20,400.00 20.00% 1117 23.70% 5,000.00 –9.09%
b.
Annual
End of Year Portfolio Value Annual S&P 500 Return Portfolio Value Annual
(George) Return Index (Change) (Daughter) Return
2008 $17,000.00 903 $5,500.00
2009 20,400.00 20.00% 1117 23.70% 5,000.00 –9.09%
2010 22,440.00 10.00% 1258 12.62% 5,510.00 10.20%
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c. The daughter’s portfolio yields a much lower return than the market with much lower risk than
the market, whereas the father’s portfolio yields about the same return as the market with
higher risk than the market.
ETHICAL DILEMMA
Drip, Drip, Drip … Should We Call a Plumber?
Ethical dilemma:
Ed Davidson is evaluating whether Freeman Plumbing Supplies should begin a dividend reinvestment plan
(DRIP). According to the plan, stockholders’ dividends would be automatically reinvested in the company’s
stock. Such a plan probably would save money for stockholders who normally reinvest their dividends in
Freeman’s stock because little or no commissions/fees are associated with DRIPs. Although Ed likes the
fact that DRIPs might benefit stockholders, he is concerned that the CEO’s primary motive for introducing
this new plan is to benefit Freeman’s executives.
Discussion questions:
• Is there an ethical problem? If so, what is it?
The question here is whether it is appropriate for Freeman Plumbing Supplies to introduce a DRIP. For
• Should Freeman start a DRIP program?
Is there an ethical dilemma here? Maybe not. If the DRIP program benefits stockholders, then is it
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• What would you do if you were Ed?
References:
The following articles might be assigned for background material:
Toddi Gutner, “Watch that DRIP,” The Wall Street Journal Online, September 12,2005.
(http://online.wsj.com/)
Eric Wahlgren, “The Return of Dividends,” The Wall Street Journal Online, October 15, 2003.
(http://online.wsj.com/)