Chapter 01 – The Investment Environment
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CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. Ultimately, it is true that real assets determine the material well being of an economy.
Nevertheless, individuals can benefit when financial engineering creates new products that
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;
(3) a well-developed system of brokerage and financial transactions, and;
3. Securitization leads to disintermediation; that is, securitization provides a means for
market participants to bypass intermediaries. For example, mortgage-backed securities
4. Financial assets make it easy for large firms to raise the capital needed to finance their
investments in real assets. If General Motors, for example, could not issue stocks or
Chapter 01 – The Investment Environment
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 information about
how the market values the firm’s investment projects. For example, if the stock price rises
6. a. Cash is a financial asset because it is the liability of the federal government.
b. No. The cash does not directly add to the productive capacity of the economy.
7. 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 (that is, Lanni’s IOU to the bank).
b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni
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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
Ratio of real assets to total assets = $30,000/$100,000 = 0.30
b.
Assets
Liabilities &
Shareholders’ equity
Software product*
$ 70,000
Bank loan
$ 50,000
Computers
30,000
Shareholders’ equity
50,000
Total
$100,000
Total
$100,000
c.
Assets
Liabilities &
Shareholders’ equity
Microsoft shares
$120,000
Bank loan
$ 50,000
Computers
30,000
Shareholders’ equity
100,000
Total
$150,000
Total
$150,000
Conclusion: when the firm starts up and raises working capital, it is characterized by
a low ratio of real assets to total assets. When it is in full production, it has a high
9. For commercial banks, the ratio is: $107.5/$10,410.9 = 0.010
10. a. Primary-market transaction
Chapter 01 – The Investment Environment
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. This structure is therefore most
c. Call options on shares of the firm create great incentives for managers to contribute to
the firm’s success. In some cases, however, stock options can lead to other agency
problems. For example, a manager with numerous call options might be tempted to
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 ownership share
In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake
13. Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
14. Treasury bills serve a purpose for investors who prefer a low-risk investment. The
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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 performance. Moreover,
top-down management is the natural way to establish a portfolio with a level of risk
consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top-
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. Financial
17. a. The SEC website defines the difference between saving and investing in terms of
the investment alternatives or the financial assets the individual chooses to acquire.
b. The economist’s definition of savings is the difference between income and
consumption. Investing is the process of allocating one’s savings among available
18. As is the case for the SEC definitions (see Problem 17), the SIA defines saving and
investing as acquisition of alternative kinds of financial assets. According to the SIA,
saving is the process of acquiring safe assets, generally from a bank, while investing is