CHAPTER 1: THE INVESTMENT ENVIRONMENT

Chapter 1 - The Investment Environment 1-1 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

CHAPTER 1: THE INVESTMENT ENVIRONMENT

PROBLEM SETS

• While it is ultimately true that real assets determine the material well-being of an

economy, financial innovation in the form of bundling and unbundling securities creates opportunities for investors to form more efficient portfolios. Both institutional and individual investors can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Bundling and unbundling create financial products with new properties and sensitivities to various sources of risk that allows investors to reduce volatility by hedging particular sources of risk more efficiently.

• Securitization requires access to a large number of potential investors. To attract

these investors, the capital market needs:

• a safe system of business laws and low probability of confiscatory

taxation/regulation;

• a well-developed investment banking industry;
• a well-developed system of brokerage and financial transactions; and
• well-developed media, particularly financial reporting.

These characteristics are found in (indeed make for) a well-developed financial market.

• Securitization leads to disintermediation; that is, securitization provides a means

for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. Securitization works well and can benefit many, but only if the market for these securities is highly liquid.As securitization progresses, however, and financial intermediaries lose opportunities, they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business and financial services.

• The existence of efficient capital markets and the liquid trading of financial assets

make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.

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• 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 considerably, managers might conclude that the market believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business.In addition, shares that can be traded in the secondary market are more attractive to initial investors since they know that they will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering and thus improves the terms on which firms can raise money in the equity market.

Remember that stock exchanges like those in New York, London, and Paris are the heart of capitalism, in which firms can raise capital quickly in primary markets because investors know there are liquid secondary markets.

• No. The increase in price did not add to the productive capacity of the

economy.

• Yes, the value of the equity held in these assets has increased.

• Future homeowners as a whole are worse off, since mortgage liabilities have

also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will suffer the damage.

• The bank loan is a financial liability for Lanni, and a financial asset for the bank.

The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note to repay the loan.

• Lanni transfers financial assets (cash) to the software developers. In return,

Lanni receives the completed software package, which is a real asset. No financial assets are created or destroyed; cash is simply transferred from one party to another.

• Lanni exchanges the real asset (the software) for a financial asset, which is 1,500

shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, then this would represent the creation of new financial assets.

• By selling its shares in Microsoft, Lanni exchanges one financial asset (1,500

shares of stock) for another ($120,000 in cash). Lanni uses the financial asset of $50,000 in cash to repay the bank and retire its promissory note. The bank must return its financial asset to Lanni. The loan is "destroyed" in the transaction, since it is retired when paid off and no longer exists.

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• 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 *Valued at cost Ratio of real assets to total assets = $100,000/$100,000 = 1.0

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 Ratio of real assets to total assets = $30,000/$150,000 = 0.20 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 ratio of real assets to total assets. When the project "shuts down" and the firm sells it off for cash, financial assets once again replace real assets.

9. For commercial banks, the ratio is: $166.1/$13,926.0 = 0.0119

For nonfinancial firms, the ratio is: $15,320/$30,649 = 0.4999

The difference should be expected primarily because the bulk of the business of financial institutions is to make loans and the bulk of non- financial corporations is to invest in equipment, manufacturing plants, and property. The loans are financial assets for financial institutions, but the investments of non-financial corporations are real assets.

• a. Primary-market transaction in which gold certificates are being offered to

public investors for the first time by an underwriting syndicate led by JW Korth Capital.