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
ownership interest. Fixed-income (debt) security pays a specified cash flow at pre-
contracted time intervals until the last payment on the maturity date. Equity has an
indefinite life.
2. The primary asset has a claim on the real assets of a firm, whereas a derivative asset
provides a payoff that depends on the prices of a primary asset but not the claim on
real assets.
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
can be addressed through corporate governance mechanisms, such as the design of
executive compensation, oversight by the Board, and monitoring from the
institutional investors.
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
money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some
commercial banks started transforming to “universal banks” which provide the
services of both commercial banks and investment banks. With the passage of the
Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall
was partially restored via the Volker Rule.
7.
a. Toyota creates a real asset—the factory. The loan is a financial asset that is
created in the transaction.
b. When the loan is repaid, the financial asset is destroyed but the real asset
continues to exist.
c. The cash is a financial asset that is traded in exchange for a real asset, inventory.
1.
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 the balance sheet of individual investors has been reduced.
c. The difference between these two answers reflects the difference between real
and financial asset values. Real assets still exist, yet the value of the claims on those
assets or the cash flows they generate do change. Thus, there is the difference.
2.
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.
b. The cash paid by Lanni is the transfer of a financial asset to the software
developer. In return, Lanni gets a real asset, the completed software. No financial
assets are created or destroyed. Cash is simply transferred from one firm to another.
c. Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni
receives a financial asset, 2,500 shares of Microsoft stock. If Microsoft issues new
shares in order to pay Lanni, this would constitute the creation of new financial
asset.
d. In selling 2,500 shares of stock for $125,000, Lanni is exchanging one financial
asset for another. In paying off the IOU with $50,000, Lanni is exchanging financial
assets. The loan is "destroyed" in the transaction, since it is retired when paid.
3.
a.
, Liabilities &
Assets Shareholders’ Equity
Cash $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
$30,000
Ratio of real to total assets = = 0.3
$100,000
b.
Liabilities &
Assets Shareholders’ Equity
Software product* $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
*Value at cost
$100,000
Ratio of real to total assets = = 1.0
$100,000
c.
Liabilities &
Assets Shareholders’ equity
Microsoft shares $125,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 105,000
Total $155,000 Total $155,000
, $30,000
Ratio of real to total assets = = 0.2
$155,000
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 ratio of real assets. When the project "shuts down" and the firm
sells it, the percentage of real assets to total assets goes down again because the
product is again exchanged into financial assets.
4. 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 potential failure becomes more threatening to other institutions. The act
seeks to unify and clarify the lines of regulatory authority and responsibility in
government agencies and to address the incentive issue by forcing employee
compensation to reflect longer-term performance. It also mandates increased
transparency, especially in derivatives markets.
$148.6
5. a. For commercial banks, the ratio is: = 0.0098
$15,164.6
$18,569
b. For non-financial firms, the ratio is: = 0.5306
$34,997
c. The difference should be expected since the business of financial institutions is to
make loans that are financial assets.
6. 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.
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
ownership interest. Fixed-income (debt) security pays a specified cash flow at pre-
contracted time intervals until the last payment on the maturity date. Equity has an
indefinite life.
2. The primary asset has a claim on the real assets of a firm, whereas a derivative asset
provides a payoff that depends on the prices of a primary asset but not the claim on
real assets.
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
can be addressed through corporate governance mechanisms, such as the design of
executive compensation, oversight by the Board, and monitoring from the
institutional investors.
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
money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some
commercial banks started transforming to “universal banks” which provide the
services of both commercial banks and investment banks. With the passage of the
Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall
was partially restored via the Volker Rule.
7.
a. Toyota creates a real asset—the factory. The loan is a financial asset that is
created in the transaction.
b. When the loan is repaid, the financial asset is destroyed but the real asset
continues to exist.
c. The cash is a financial asset that is traded in exchange for a real asset, inventory.
1.
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 the balance sheet of individual investors has been reduced.
c. The difference between these two answers reflects the difference between real
and financial asset values. Real assets still exist, yet the value of the claims on those
assets or the cash flows they generate do change. Thus, there is the difference.
2.
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.
b. The cash paid by Lanni is the transfer of a financial asset to the software
developer. In return, Lanni gets a real asset, the completed software. No financial
assets are created or destroyed. Cash is simply transferred from one firm to another.
c. Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni
receives a financial asset, 2,500 shares of Microsoft stock. If Microsoft issues new
shares in order to pay Lanni, this would constitute the creation of new financial
asset.
d. In selling 2,500 shares of stock for $125,000, Lanni is exchanging one financial
asset for another. In paying off the IOU with $50,000, Lanni is exchanging financial
assets. The loan is "destroyed" in the transaction, since it is retired when paid.
3.
a.
, Liabilities &
Assets Shareholders’ Equity
Cash $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
$30,000
Ratio of real to total assets = = 0.3
$100,000
b.
Liabilities &
Assets Shareholders’ Equity
Software product* $70,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
*Value at cost
$100,000
Ratio of real to total assets = = 1.0
$100,000
c.
Liabilities &
Assets Shareholders’ equity
Microsoft shares $125,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 105,000
Total $155,000 Total $155,000
, $30,000
Ratio of real to total assets = = 0.2
$155,000
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 ratio of real assets. When the project "shuts down" and the firm
sells it, the percentage of real assets to total assets goes down again because the
product is again exchanged into financial assets.
4. 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 potential failure becomes more threatening to other institutions. The act
seeks to unify and clarify the lines of regulatory authority and responsibility in
government agencies and to address the incentive issue by forcing employee
compensation to reflect longer-term performance. It also mandates increased
transparency, especially in derivatives markets.
$148.6
5. a. For commercial banks, the ratio is: = 0.0098
$15,164.6
$18,569
b. For non-financial firms, the ratio is: = 0.5306
$34,997
c. The difference should be expected since the business of financial institutions is to
make loans that are financial assets.
6. 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.
