CHAPTER 1: THE INVESTMENT ENVIRONMENT

CHAPTER 1: THE INVESTMENT ENVIRONMENT

PROBLEM SETS 1. Ultimately, it is true that real assets determi e the material !ell "ei # $% a e&$ $my. Ne'ertheless, i di'iduals &a "e e%it !he %i a &ial e #i eeri # &reates e! (r$du&ts that all$! them t$ ma a#e their ($rt%$li$s $% %i a &ial assets m$re e%%i&ie tly. )e&ause "u dli # a d u "u dli # &reates %i a &ial (r$du&ts !ith e! (r$(erties a d se siti'ities t$ 'ari$us s$ur&es $% ris*, it all$!s i 'est$rs t$ hed#e (arti&ular s$ur&es $% ris* m$re e%%i&ie tly. Se&uriti,ati$ re-uires a&&ess t$ a lar#e um"er $% ($te tial i 'est$rs. T$ attra&t these i 'est$rs, the &a(ital mar*et eeds: 1. a sa%e system $% "usi ess la!s a d l$! (r$"a"ility $% &$ %is&at$ry ta.ati$ /re#ulati$ 0 +. a !ell1de'el$(ed i 'estme t "a *i # i dustry0 2. a !ell1de'el$(ed system $% "r$*era#e a d %i a &ial tra sa&ti$ s, a d0 3. !ell1de'el$(ed media, (arti&ularly %i a &ial re($rti #. These &hara&teristi&s are %$u d i 4i deed ma*e %$r5 a !ell1de'el$(ed %i a &ial mar*et. 2. Se&uriti,ati$ leads t$ disi termediati$ 0 that is, se&uriti,ati$ (r$'ides a mea s %$r mar*et (arti&i(a ts t$ "y(ass i termediaries. 6$r e.am(le, m$rt#a#e1"a&*ed se&urities &ha el %u ds t$ the h$usi # mar*et !ith$ut re-uiri # that "a *s $r thri%t i stituti$ s ma*e l$a s %r$m their $! ($rt%$li$s. As se&uriti,ati$ (r$#resses, %i a &ial i termediaries must i &rease $ther a&ti'ities su&h as (r$'idi # sh$rt1term li-uidity t$ &$ sumers a d small "usi ess, a d %i a &ial ser'i&es. 6i a &ial assets ma*e it easy %$r lar#e %irms t$ raise the &a(ital eeded t$ %i a &e their i 'estme ts i real assets. I% 6$rd, %$r e.am(le, &$uld $t issue st$&*s $r "$ ds t$ the #e eral (u"li&, it !$uld ha'e a %ar m$re di%%i&ult time raisi # &a(ital. C$ tra&ti$ $% the su((ly $% %i a &ial assets !$uld ma*e %i a &i # m$re di%%i&ult, there"y i &reasi # the &$st $% &a(ital. A hi#her &$st $% &a(ital results i less i 'estme t a d l$!er real #r$!th.

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3.

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7.

E'e i% the %irm d$es $t eed t$ issue st$&* i a y (arti&ular year, the st$&* mar*et is still im($rta t t$ the %i a &ial ma a#er. The st$&* (ri&e (r$'ides im($rta t i %$rmati$ a"$ut h$! the mar*et 'alues the %irm8s i 'estme t (r$9e&ts. 6$r e.am(le, i% the st$&* (ri&e rises &$ sidera"ly, ma a#ers mi#ht &$ &lude that the mar*et "elie'es the %irm8s %uture (r$s(e&ts are "ri#ht. This mi#ht "e a use%ul si# al t$ the %irm t$ (r$&eed !ith a i 'estme t su&h as a e.(a si$ $% the %irm8s "usi ess. I additi$ , shares that &a "e traded i the se&$ dary mar*et are m$re attra&ti'e t$ i itial i 'est$rs si &e they * $! that they !ill "e a"le t$ sell their shares. This i tur ma*es i 'est$rs m$re !illi # t$ "uy shares i a (rimary $%%eri #, a d thus im(r$'es the terms $ !hi&h %irms &a raise m$ ey i the e-uity mar*et.

:.

a. N$. The i &rease i (ri&e did $t add t$ the (r$du&ti'e &a(a&ity $% the e&$ $my. ". ;es, the 'alue $% the e-uity held i these assets has i &reased. &. 6uture h$me$! ers as a !h$le are !$rse $%%, si &e m$rt#a#e lia"ilities ha'e als$ i &reased. I additi$ , this h$usi # (ri&e "u""le !ill e'e tually "urst a d s$&iety as a !h$le 4a d m$st li*ely ta.(ayers5 !ill e dure the dama#e.

<.

a. The "a * l$a is a %i a &ial lia"ility %$r =a i. 4=a i8s IOU is the "a *8s %i a &ial asset.5 The &ash =a i re&ei'es is a %i a &ial asset. The e! %i a &ial asset &reated is =a i8s (r$miss$ry $te 4that is, =a i>s IOU t$ the "a *5. ". =a i tra s%ers %i a &ial assets 4&ash5 t$ the s$%t!are de'el$(ers. I retur , =a i #ets a real asset, the &$m(leted s$%t!are. N$ %i a &ial assets are &reated $r destr$yed0 &ash is sim(ly tra s%erred %r$m $ e (arty t$ a $ther. &. =a i #i'es the real asset 4the s$%t!are5 t$ Mi&r$s$%t i e.&ha #e %$r a %i a &ial asset, 1,7?? shares $% Mi&r$s$%t st$&*. I% Mi&r$s$%t issues e! shares i $rder t$ (ay =a i, the this !$uld re(rese t the &reati$ $% e! %i a &ial assets. d. =a i e.&ha #es $ e %i a &ial asset 41,7?? shares $% st$&*5 %$r a $ther 4@1+?,???5. =a i #i'es a %i a &ial asset 4@7?,??? &ash5 t$ the "a * a d #ets "a&* a $ther %i a &ial asset 4its IOU5. The l$a is Adestr$yedA i the tra sa&ti$ , si &e it is retired !he (aid $%% a d $ l$ #er e.ists.

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CHAPTER 1: THE INVESTMENT ENVIRONMENT

B.

a. Liabilities & Shareholders equity Cash @ <?,??? )a * l$a @ 7?,??? C$m(uters 2?,??? Shareh$lders> e-uity 7?,??? T$tal @1??,??? T$tal @1??,??? Rati$ $% real assets t$ t$tal assets C @2?,???/@1??,??? C ?.2? Assets ". Assets S$%t!are (r$du&tD C$m(uters T$tal DValued at &$st Rati$ $% real assets t$ t$tal assets C @1??,???/@1??,??? C 1.? &. Assets Mi&r$s$%t shares C$m(uters T$tal @1+?,??? 2?,??? @17?,??? Liabilities & Shareholders equity )a * l$a @ 7?,??? Shareh$lders> e-uity 1??,??? T$tal @17?,??? @ <?,??? 2?,??? @1??,??? Liabilities & Shareholders equity )a * l$a @ 7?,??? Shareh$lders> e-uity 7?,??? T$tal @1??,???

Rati$ $% real assets t$ t$tal assets C @2?,???/@17?,??? C ?.+? C$ &lusi$ : !he the %irm starts u( a d raises !$r*i # &a(ital, it is &hara&teri,ed "y a l$! rati$ $% real assets t$ t$tal assets. Ehe it is i %ull (r$du&ti$ , it has a hi#h rati$ $% real assets t$ t$tal assets. Ehe the (r$9e&t Ashuts d$! A a d the %irm sells it $%% %$r &ash, %i a &ial assets $ &e a#ai re(la&e real assets. F. 6$r &$mmer&ial "a *s, the rati$ is: @13?.1/@11,BF7.1 C ?.?11B 6$r $ 1%i a &ial %irms, the rati$ is: @1+,72B/@+:,7<+ C ?.3<1F The di%%ere &e sh$uld "e e.(e&ted (rimarily "e&ause the "ul* $% the "usi ess $% %i a &ial i stituti$ s is t$ ma*e l$a s0 !hi&h are %i a &ial assets %$r %i a &ial i stituti$ s. a. Primary1mar*et tra sa&ti$ ". Geri'ati'e assets &. I 'est$rs !h$ !ish t$ h$ld #$ld !ith$ut the &$m(li&ati$ a d &$st $% (hysi&al st$ra#e.

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11.

a. A %i.ed salary mea s that &$m(e sati$ is 4at least i the sh$rt ru 5 i de(e de t $% the %irm8s su&&ess. This salary stru&ture d$es $t tie the ma a#er>s immediate &$m(e sati$ t$ the su&&ess $% the %irm. H$!e'er, the ma a#er mi#ht 'ie! this as the sa%est &$m(e sati$ stru&ture a d there%$re 'alue it m$re hi#hly. ". A salary that is (aid i the %$rm $% st$&* i the %irm mea s that the ma a#er ear s the m$st !he the shareh$lders> !ealth is ma.imi,ed. 6i'e years $% 'esti # hel(s ali# the i terests $% the em(l$yee !ith the l$ #1term (er%$rma &e $% the %irm. This stru&ture is there%$re m$st li*ely t$ ali# the i terests $% ma a#ers a d shareh$lders. I% st$&* &$m(e sati$ is $'erd$ e, h$!e'er, the ma a#er mi#ht 'ie! it as $'erly ris*y si &e the ma a#er>s &areer is already li *ed t$ the %irm, a d this u di'ersi%ied e.($sure !$uld "e e.a&er"ated !ith a lar#e st$&* ($siti$ i the %irm. &. A (r$%it1li *ed salary &reates #reat i &e ti'es %$r ma a#ers t$ &$ tri"ute t$ the %irm>s su&&ess. H$!e'er, a ma a#er !h$se salary is tied t$ sh$rt1term (r$%its !ill "e ris* see*i #, es(e&ially i% these sh$rt1term (r$%its determi e salary $r i% the &$m(e sati$ stru&ture d$es $t "ear the %ull &$st $% the (r$9e&t>s ris*s. Shareh$lders, i &$ trast, "ear the l$sses as !ell as the #ai s $ the (r$9e&t, a d mi#ht "e less !illi # t$ assume that ris*.

1+.

E'e i% a i di'idual shareh$lder &$uld m$ it$r a d im(r$'e ma a#ers> (er%$rma &e, a d there"y i &rease the 'alue $% the %irm, the (ay$%% !$uld "e small, si &e the $! ershi( share i a lar#e &$r($rati$ !$uld "e 'ery small. 6$r e.am(le, i% y$u $! @1?,??? $% 6$rd st$&* a d &a i &rease the 'alue $% the %irm "y 7H, a 'ery am"iti$us #$al, y$u "e e%it "y $ ly: ?.?7 @1?,??? C @7?? I &$ trast, a "a * that has a multimilli$ 1d$llar l$a $utsta di # t$ the %irm has a "i# sta*e i ma*i # sure that the %irm &a re(ay the l$a . It is &learly !$rth!hile %$r the "a * t$ s(e d &$ sidera"le res$ur&es t$ m$ it$r the %irm.

12.

Mutual %u ds a&&e(t %u ds %r$m small i 'est$rs a d i 'est, $ "ehal% $% these i 'est$rs, i the ati$ al a d i ter ati$ al se&urities mar*ets. Pe si$ %u ds a&&e(t %u ds a d the i 'est, $ "ehal% $% &urre t a d %uture retirees, there"y &ha eli # %u ds %r$m $ e se&t$r $% the e&$ $my t$ a $ther. Ve ture &a(ital %irms ($$l the %u ds $% (ri'ate i 'est$rs a d i 'est i start1u( %irms. )a *s a&&e(t de($sits %r$m &ust$mers a d l$a th$se %u ds t$ "usi esses, $r use the %u ds t$ "uy se&urities $% lar#e &$r($rati$ s. Treasury "ills ser'e a (ur($se %$r i 'est$rs !h$ (re%er a l$!1ris* i 'estme t. The l$!er a'era#e rate $% retur &$m(ared t$ st$&*s is the (ri&e i 'est$rs (ay %$r (redi&ta"ility $% i 'estme t (er%$rma &e a d ($rt%$li$ 'alue.

13.

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17.

Eith a It$(1d$! J i 'esti # style, y$u %$&us $ asset all$&ati$ $r the "r$ad &$m($siti$ $% the e tire ($rt%$li$, !hi&h is the ma9$r determi a t $% $'erall (er%$rma &e. M$re$'er, t$(1d$! ma a#eme t is the atural !ay t$ esta"lish a ($rt%$li$ !ith a le'el $% ris* &$ siste t !ith y$ur ris* t$lera &e. The disad'a ta#e $% a exclusive em(hasis $ t$(1d$! issues is that y$u may %$r%eit the ($te tial hi#h retur s that &$uld result %r$m ide ti%yi # a d &$ &e trati # i u der'alued se&urities $r se&t$rs $% the mar*et. Eith a I"$tt$m1u(J i 'esti # style, y$u try t$ "e e%it %r$m ide ti%yi # u der'alued se&urities. The disad'a ta#e is that y$u te d t$ $'erl$$* the $'erall &$m($siti$ $% y$ur ($rt%$li$, !hi&h may result i a $ 1di'ersi%ied ($rt%$li$ $r a ($rt%$li$ !ith a ris* le'el i &$ siste t !ith y$ur le'el $% ris* t$lera &e. I additi$ , this te&h i-ue te ds t$ re-uire m$re a&ti'e ma a#eme t, thus #e erati # m$re tra sa&ti$ &$sts. 6i ally, y$ur a alysis may "e i &$rre&t, i !hi&h &ase y$u !ill ha'e %ruitlessly e.(e ded e%%$rt a d m$ ey attem(ti # t$ "eat a sim(le "uy1a d1h$ld strate#y.

1:.

;$u sh$uld "e s*e(ti&al. I% the auth$r a&tually * $!s h$! t$ a&hie'e su&h retur s, $ e must -uesti$ !hy the auth$r !$uld the "e s$ ready t$ sell the se&ret t$ $thers. 6i a &ial mar*ets are 'ery &$m(etiti'e0 $ e $% the im(li&ati$ s $% this %a&t is that ri&hes d$ $t &$me easily. Hi#h e.(e&ted retur s re-uire "eari # s$me ris*, a d $"'i$us "ar#ai s are %e! a d %ar "et!ee . Odds are that the $ ly $ e #etti # ri&h %r$m the "$$* is its auth$r. 6i a &ial assets (r$'ide %$r a mea s t$ a&-uire real assets as !ell as a e.(a si$ $% these real assets. 6i a &ial assets (r$'ide a measure $% li-uidity t$ real assets a d all$! %$r i 'est$rs t$ m$re e%%e&ti'ely redu&e ris* thr$u#h di'ersi%i&ati$ . All$!i # traders t$ share i the (r$%its i &reases the traders> !illi # ess t$ assume ris*. Traders !ill share i the u(side ($te tial dire&tly "ut $ ly i the d$! side i dire&tly 4($$r (er%$rma &e C ($te tial 9$" l$ss5. Shareh$lders, "y &$ trast, are a%%e&ted dire&tly "y "$th the u(side a d d$! side ($te tial $% ris*. A s!ers may 'ary, h$!e'er, stude ts sh$uld t$u&h $ the %$ll$!i #: i &reased tra s(are &y, re#ulati$ s t$ (r$m$te &a(ital ade-ua&y "y i &reasi # the %re-ue &y $% #ai $r l$ss settleme t, i &e ti'es t$ dis&$ura#e e.&essi'e ris* ta*i #, a d the (r$m$ti$ $% m$re a&&urate a d u "iased ris* assessme t.

1<.

1B.

1F.

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