Financial Markets and Investments: Solutions for Chapter 2 - Prof. Mary R. Brown, Assignments of Business Finance

Download Financial Markets and Investments: Solutions for Chapter 2 - Prof. Mary R. Brown and more Assignments Business Finance in PDF only on Docsity! Solutions to Chapter 2 The Financial Environment 1. Yes. When the corporation retains cash and reinvests in the firm’s operations, that cash is saved and invested on behalf of the firm’s shareholders. The reinvested cash could have been paid out to the shareholders. By not taking the cash, these investors have reinvested their savings in the corporation. Individuals can also save and invest in a corporation by lending to, or buying shares in, a financial intermediary such as a bank or mutual fund that subsequently invests in the corporation. 2. “Over-the-counter” refers to trading that does not take place on a centralized exchange such as the New York Stock Exchange. Trading of securities on NASDAQ is over-the-counter, because NASDAQ is a network of security dealers linked by computers. Although some corporate bonds are traded on the New York Stock Exchange, most corporate bonds are traded over-the-counter, as are all U.S. Treasury securities. Foreign exchange trading is also over-the-counter. 3. Money markets, where short-term debt instruments are bought and sold. Foreign-exchange markets. Most trading takes place in over-the-counter transactions between the major international banks. Commodities markets for agricultural commodities, fuels (including crude oil and natural gas) and metals (such as gold, silver and platinum). Derivatives markets, where options and other derivative instruments are traded. 4. Buy shares in a mutual fund. Mutual funds pool savings from many individual investors and then invest in a diversified portfolio of securities. Each individual investor then owns a proportionate share of the mutual fund’s portfolio. 5. Defined contribution pension plans provide three key advantages as vehicles for retirement savings:  Professional management.  Diversification at low cost.  Pension plan contributions are tax-deductible, and taxes on the earnings in the fund are deferred until the fund’s assets are distributed to retired employees. 2-1 6. Yes. Insurance companies sell policies and then invest part of the proceeds in corporate bonds and stocks and in direct loans to corporations. The returns from these investments help pay for losses incurred by policyholders. 7. The largest institutional investors in bonds are insurance companies. Other major institutional investors in bonds are pension funds, mutual funds, and banks and other savings institutions. The largest institutional investors in shares are pension funds, mutual funds, and insurance companies. 8. The market price of gold can be observed from transactions in commodity markets. For example, gold is traded on the Comex division of the New York Mercantile Exchange. Look up the price of gold and compare it to $1500/6 = $250 per ounce. 9. Financial markets provide extensive data that can be useful to financial managers. Examples include:  Prices for agricultural commodities, metals and fuels.  Interest rates for a wide array of loans and securities, including money market instruments, corporate and U.S. government bonds, and interest rates for loans and investments in foreign countries.  Foreign exchange rates.  Stock prices and overall market values for publicly listed corporations are determined by trading on the New York Stock Exchange, NASDAQ or stock markets in London, Frankfurt, Tokyo, etc. 10. The opportunity cost of capital is the expected rate of return offered by the best alternative investment opportunity. When the firm makes capital investments on behalf of the owners of the firm (i.e., the shareholders), it must consider the shareholders’ other investment opportunities. The firm should not invest unless the expected return on investment at least equals the expected return the shareholders could obtain on their own by investing in the financial markets. The opportunity cost of capital for a safe investment is the rate of return that shareholders could earn if they invested in risk-free securities, for example in U. S. Treasuries. 11. a. False. Financing could flow through an intermediary, for example. b. False. Investors can buy shares in a private corporation, for example. c. True. Sale of insurance policies are the largest source of financing for insurance companies, which then invest a significant portion of the proceeds in corporate debt and equities. d. False. There is no centralized FOREX exchange. Foreign exchange is traded over-the-counter. 2-2