Investments 13e By Zvi Bodie, Alex Kane, Alan Marcus (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) All Chapters Solutions Manual Supplement files download link at the end of this file. CHAPTER 1: THE INVESTMENT ENVIRONMENT PROBLEM SETS 1.
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 (or increase, depending on the strategy) volatility by hedging sources of risk more efficiently. Estimated Time: 1–5 min 2.
Securitization requires access to many potential investors. To attract these investors, the capital market needs: 1. a safe system of business laws and low probability of confiscatory taxation/regulation; 2. a well-developed investment banking industry; 3. a well-developed system of brokerage and financial transactions; and 4. well-developed media, particularly financial reporting.
These characteristics are found in (and make for) a well-developed capital market. Estimated Time: 1–5 min 3.
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, financial intermediaries lose opportunities; they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business as well as other financial services. Estimated Time: 1–5 min
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4.
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. Suppose Ford or Amazon could not issue stocks or bonds to the public, it would far more difficult raising capital. Contraction of the supply of financial assets and access to that supply would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth. Estimated Time: 1–5 min
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 and ultimately the decisions of the managers. For example, if the stock price rises considerably, managers might conclude that the market believes the firm’s 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. Firms can raise capital quickly in primary markets because investors know there are liquid secondary markets. Estimated Time: 1–5 min
6. a. No. The increase in price did not add to the productive capacity of the economy. b. Yes, the value of the equity held in these assets has increased. c. Future homeowners 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. Estimated Time: 1–5 min
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7. a. 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. b. 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. c. Lanni exchanges the real asset (the software) for a financial asset, which is 1,250 shares of Microsoft stock. If Microsoft issues new shares to pay Lanni, then this represents the creation of new financial assets. d. By selling its shares in Microsoft, Lanni exchanges one financial asset (1,250 shares of stock) for another ($125,000 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. Estimated Time: 1–5 min 8. a. Assets Cash Computers Total
$ 70,000 30,000 $100,000
Liabilities & Shareholders’ Equity Bank loan Shareholders’ equity Total
$ 50,000 50,000 $100,000
Ratio of real assets to total assets = $30, 000 $100, 000 = 0.30
b. Assets Software product* Computers Total
$ 70,000 30,000 $100,000
Liabilities & Shareholders’ Equity Bank loan Shareholders’ equity Total
$ 50,000 50,000 $100,000
*Valued at cost Ratio of real assets to total assets = $100, 000 $100, 000 = 1.0
c. Assets Microsoft shares Computers Total
$125,000 30,000 $155,000
Liabilities & Shareholders’ Equity Bank loan Shareholders’ equity Total
$ 50,000 105,000 $155,000
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Ratio of real assets to total assets = $30, 000 $155, 000 = 0.19
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. Estimated Time: 1–5 min 9.
a. For commercial banks, the ratio is: $191.9 / $22, 564.2 = 0.0085 or 0.85%. b. For nonfinancial firms, the ratio is: $25, 974 / $50,856 = 0.5107 or 51.07%. c. The difference should be expected primarily because the bulk of the business of financial institutions is to make loans and the bulk of the business of nonfinancial corporations is to invest in equipment, manufacturing plants, and property. The loans are financial assets for financial institutions, but the investments of nonfinancial corporations are real assets. Estimated Time: 1–5 min 10. 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. b. The certificates are derivative assets because while represent an investment in physical gold, each investor receives a certificate and no gold. Note that investors can convert the certificate into gold during the 4-year period. The security’s value is derived from gold. Estimated Time: 1–5 min 11. a. A fixed salary means that compensation is, 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, so a manager might not feel too compelled to work hard to maximize firm value. However, the manager might view this as the safest compensation structure and therefore value it more highly. 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. Five years of vesting helps align the interests of the employee with the long-term performance of the firm. This structure is therefore most likely to align the interests of managers and shareholders. If stock compensation is overdone, however, the manager might view
CHAPTER 1: THE INVESTMENT ENVIRONMENT
it as overly risky since the manager’s career is already linked to the firm, and this undiversified exposure would be exacerbated with a large stock position in the firm. c. A profit-linked salary creates great incentives for managers to contribute to the firm’s success. However, a manager whose salary is tied to short-term profits will be risk seeking, especially if these short-term profits determine salary or if the compensation structure does not bear the full cost of the project’s risks (e.g., docked pay for failed projects). Shareholders, in contrast, bear the losses as well as the gains on the project and might be less willing to assume that risk. Estimated Time: 1–5 min 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 a large corporation would be very small. For example, if you own $10,000 of Ford stock and can increase the value of the firm by 5%, a very ambitious goal, you benefit by only: 0.05$10, 000 = $500 . The cost, both personal and financial to an individual investor, is likely to be prohibitive and would typically easily exceed any accrued benefits (in this case $500). In contrast, a creditor, such as a bank, that has a multimillion-dollar loan outstanding to the firm has a big stake in making sure that the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm. Large institutional investors will also have commensurately large positions in companies and will therefore monitor more closely. Estimated Time: 1–5 min 12.
13.
Answers may vary: • Mutual funds accept funds from small investors and invest, on behalf of these investors, in the domestic and international securities markets. •
Pension funds accept funds and then invest in a wide range of financial securities, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another.
•
Venture capital firms pool the funds of private investors and invest in start-up firms.
•
Leveraged buyout funds pool the funds of private investors and, with large amounts of debt, purchase publicly traded companies.
•
Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations. Estimated Time: 1–5 min 14.
Treasury bills serve a purpose for investors who prefer a low-risk investment with immense liquidity. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.
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Estimated Time: 1–5 min 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-down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market. With a bottom-up investing style, you benefit from identifying undervalued securities. The disadvantage is that you might overlook the overall composition of your portfolio, resulting in a nondiversified portfolio or a portfolio with a risk level inconsistent with the appropriate level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, the bottom-up analysis may be incorrect, expended effort and money fail to beat a simple buy-andhold strategy. Estimated Time: 1–5 min 16.
You should be skeptical. If the author knows how to achieve such returns, why would the author then be so ready to sell the secret to others? Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High-expected returns require bearing some risk, and obvious bargains are few and far between. Any bargains, once discovered by the broad market, disappear quickly. Odds are that the only one getting rich from the book is its author. Estimated Time: 1–5 min 17.
Financial assets provide for a means to acquire real assets as well as an expansion of these real assets. Financial assets provide a measure of liquidity to real assets and allow for investors to reduce risk more effectively through diversification. Estimated Time: 1–5 min Allowing traders to share in the profits increases the traders’ willingness to assume risk. Traders will share in the upside potential directly in the form of higher compensation but only in the downside indirectly in the form of potential job loss if performance is bad enough. This scenario creates a form of agency conflict known as moral hazard, in which the owners of the financial institution share in both the total profits and losses, while the traders will tend to share more of the gains than the losses. Estimated Time: 1–5 min 18.
19.
Answers may vary, however, students should touch on the following: increased transparency, regulations to promote capital adequacy by increasing the frequency
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of gain or loss settlement, incentives to discourage excessive risk-taking, and the promotion of more accurate and unbiased risk assessment. Estimated Time: 1–5 min
Chapter 2: ASSET CLASSES AND FINANCIAL INSTRUMENTS
CHAPTER 2: ASSET CLASSES AND FINANCIAL INSTRUMENTS PROBLEM SETS 1.
Preferred stock is like long-term debt in that it typically promises a fixed payment each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not give the holder voting rights in the firm.
Preferred stock is like equity in that the firm is under no contractual obligation to make the preferred stock dividend payments. Failure to make payments does not set off corporate bankruptcy. With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds. Estimated Time: 1–5 min 2.
Money market securities are called cash equivalents because of their high level of liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs. Examples of money market securities include Treasury bills, commercial paper, and banker’s acceptances, each of which is highly marketable and traded in the secondary market. Estimated Time: 1–5 min 3. (a) A repurchase agreement is an agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price. Repos are typically used by securities dealers as a means for obtaining funds to purchase securities. Estimated Time: 1–5 min 4.
Spreads between risky commercial paper and risk-free government securities will widen. Deterioration of the economy increases the likelihood of default on commercial paper, making these assets riskier. Investors will demand a greater premium on all risky debt securities, not just commercial paper. Estimated Time: 1–5 min
Chapter 2: ASSET CLASSES AND FINANCIAL INSTRUMENTS
5. Corporate Bonds Voting rights (typically) Contractual obligation Perpetual payments Accumulated dividends Fixed payments (typically) Payment preference Estimated Time: 1–5 min
Preferred Stock
Common Stock Yes
Yes Yes Yes Second
Yes
Yes
Yes First
Third
6.
Municipal bond interest is tax-exempt at the federal level and possibly at the state level as well. When facing higher marginal tax rates, a high-income investor would be more inclined to invest in tax-exempt securities. Estimated Time: 1–5 min 7. a.
You would have to pay the ask price of: 139.180% of par value of $1,000 = $1,391.80
b.
The coupon rate is 4.250%; implying coupons $42.50 annually or more precisely $21.25 (semiannually).
c.
The yield to maturity on a fixed income security is also known as its required return and is reported by The Wall Street Journal and others in the financial press as the ask yield. In this case, the yield to maturity is 1.815%. An investor buying this security today and holding it until it matures will earn an annual return of 1.815%. Students will learn in a later chapter how to compute both the price and the yield to maturity with a financial calculator (as well as some of the other implications of yield calculations). Estimated Time: 1–5 min 8.
Treasury bills are discount securities that mature for $10,000. A 6-month T-bill price is the value divided by one plus the semi-annual return: P = $10, 000 / 1.02 = $9, 803.92 Estimated Time: 1–5 min 9.
The total before-tax income is $4. After the 50% corporate exclusion for preferred stock dividends, the taxable income is: 0.50 $4 = $2.00 Therefore, taxes are: 0.21$2.00 = $0.42 After-tax income is: $4.00 − $0.42 = $3.58 Rate of return is: $3.58 / $40.00 = 8.95%
Chapter 2: ASSET CLASSES AND FINANCIAL INSTRUMENTS
Estimated Time: 1–5 min 10. a.
You could buy: $5, 000 / $227.22 = 22.01 shares. Since it is not possible to trade in fractions of shares, you could buy 22 shares of Honeywell.
b.
Your annual dividend income would be: 22$3.72 = $81.84
c.
The price-to-earnings ratio is 34.87 and the price is $227.22. Therefore: P $227.22 = 34.87 = → E.P.S. = $6.52 E E.P.S
d.
Honeywell closed today at $227.22, which was $3.69 higher than yesterday’s price of $223.53. Estimated Time: 1–5 min 11. a.
At t = 0, the value of the index is: (90 + 50 +100) / 3 = 80.00 At t = 1, the value of the index is: (95 + 45 +110) / 3 = 83.33 The rate of return is: (83.333 / 80) −1 = 4.17% .
b.
In the absence of a split, Stock C would sell for 110, so the value of the index would be: (95 + 45 +110) / 3 = 250 / 3 = 83.33 with a divisor of 3. After the split, stock C sells for 55. Therefore, we need to find the divisor (d) such that: 83.33 = (95 + 45 + 55) / d d = 2.340. The divisor fell, which is always the case after a firm in an index splits its shares.
c.
The return is zero. The index remains unchanged because the return for each stock separately equals zero. Estimated Time: 1–5 min 12. a.
Total market value at t = 0 is: $90 100 + $50 200 + $100 200 = $39, 000 Total market value at t = 1 is: $95100 + $45 200 + $100 200 = $40, 500 Rate of return = ($40, 500 / $39, 000) −1 = 3.85%
Chapter 2: CLASSES FINANCIAL b.ASSETThe returnAND on each stock is INSTRUMENTS as follows: