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.
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.
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.
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 them more risky. Investors will demand a greater
premium on all risky debt securities, not just commercial paper.
5.
Corp. Bonds Preferred Stock Common Stock
Voting rights (typically) Yes
contractual obligation Yes
Perpetual payments Yes Yes
Accumulated dividends Yes
Fixed payments (typically) Yes Yes
Payment preference First Second Third
2-1
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
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, Chapter 2 - Asset Classes and Financial Instruments
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.
7. a. You would have to pay the ask price of:
101.9297% of par value of $1,000 = $1,019.297
b. The coupon rate is 3.000%; implying coupon payments of $30.00 annually
or, more precisely $15.00 (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 2.902%. An investor
buying this security today and holding it until it matures will earn an annual
return of 2.902%. Students will learn in a later chapter how to compute both
the price and the yield to maturity with a financial calculator.
8. Treasury bills are discount securities that mature for $10,000. Therefore, a specific T-
bill price is simply the maturity value divided by one plus the semi-annual return:
P = $10,000/1.02 = $9,803.92
9. The total before-tax income is $4. After the 50% exclusion for preferred stock
dividends, the taxable income is: 0.50 $4 = $2.00
Therefore, taxes are: 0.30 $2.00 = $0.60
After-tax income is: $4.00 – $0.60 = $3.40
Rate of return is: $3.40/$40.00 = 8.50%
10. a. You could buy: $5,000/$57.94 = 86.30 shares. Since it is not possible to trade
in fractions of shares, you could buy 86 shares of Herbalife.
b. Your annual dividend income would be: 86 $1.20 = $103.20
c. The price-to-earnings ratio is 47.75 and the price is $57.94. Therefore:
$57.94/Earnings per share = 47.75 Earnings per share = $1.21
d. Herbalife closed today at $57.94, which was $1.39 lower than yesterday’s
price of $59.33.
2-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
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.
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.
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.
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 them more risky. Investors will demand a greater
premium on all risky debt securities, not just commercial paper.
5.
Corp. Bonds Preferred Stock Common Stock
Voting rights (typically) Yes
contractual obligation Yes
Perpetual payments Yes Yes
Accumulated dividends Yes
Fixed payments (typically) Yes Yes
Payment preference First Second Third
2-1
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
, Chapter 2 - Asset Classes and Financial Instruments
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.
7. a. You would have to pay the ask price of:
101.9297% of par value of $1,000 = $1,019.297
b. The coupon rate is 3.000%; implying coupon payments of $30.00 annually
or, more precisely $15.00 (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 2.902%. An investor
buying this security today and holding it until it matures will earn an annual
return of 2.902%. Students will learn in a later chapter how to compute both
the price and the yield to maturity with a financial calculator.
8. Treasury bills are discount securities that mature for $10,000. Therefore, a specific T-
bill price is simply the maturity value divided by one plus the semi-annual return:
P = $10,000/1.02 = $9,803.92
9. The total before-tax income is $4. After the 50% exclusion for preferred stock
dividends, the taxable income is: 0.50 $4 = $2.00
Therefore, taxes are: 0.30 $2.00 = $0.60
After-tax income is: $4.00 – $0.60 = $3.40
Rate of return is: $3.40/$40.00 = 8.50%
10. a. You could buy: $5,000/$57.94 = 86.30 shares. Since it is not possible to trade
in fractions of shares, you could buy 86 shares of Herbalife.
b. Your annual dividend income would be: 86 $1.20 = $103.20
c. The price-to-earnings ratio is 47.75 and the price is $57.94. Therefore:
$57.94/Earnings per share = 47.75 Earnings per share = $1.21
d. Herbalife closed today at $57.94, which was $1.39 lower than yesterday’s
price of $59.33.
2-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
