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
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.
4. Agency problems are conflicts of interest between managers and stockholders. They
5. Real assets are assets used to produce goods and services. Financial assets are claims on
real assets or the income generated by them.
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. a. Toyota creates a real asset—the factory. The loan is a financial asset that is created
in the transaction.
8. a. No. The real estate in existence has not changed, only the perception of its value has.
b. Yes. The financial asset value of the claims on the real estate has changed, and thus
9. a. The bank loan is a financial liability for Lanni. Lanni’s 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
Assets
Liabilities &
Shareholders’ Equity
b.
Software product* $70,000 Bank loan $50,000
Assets
Liabilities &
Shareholders’ Equity
Chapter 01 – Investments: Background and Issues
c.
Microsoft shares
$125,000 Bank loan $50,000
Assets
Conclusion: When the firm starts up and raises working capital, it will be characterized
by a low ratio of real to total assets. When it is in full production, it will have a high
11. Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act
proposes several mechanisms to mitigate systemic risk. The act attempts to limit the
risky activities in which the banks can engage and calls for stricter rules for bank capital,
liquidity, and risk management practices, especially as banks become larger and their
12. a. For commercial banks, the ratio is:
6.164,15$
6.148$
= 0.0098
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
14. 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
b. A salary paid in the form of stock in the firm means the manager earns the most
when shareholder wealth is maximized. When the stock must be held for five
years, the manager has less of an incentive to manipulate the stock price. This
c. When executive salaries are linked to firm profits, the firm creates incentives for
managers to contribute to the firm’s success. However, this may also lead 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
ownership in a large corporation is so small compared to that of institutional investors.
For example, if the individual investor owns $10,000 of IBM stock and can increase the
value of the firm by 5%, a very ambitious goal, the benefit would only be: $10,000 x
5% = $500.
16. Since the traders benefited from profits but did not get penalized by losses, they were
(1) A safe system of business laws and low probability of confiscatory
taxation/regulation;
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. Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
Pension funds accept funds and then invest, on behalf of current and future retirees,
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
about how the market values the firm’s investment projects. For example, if the stock
21. Treasury bills serve a purpose for investors who prefer a low-risk investment. The
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.