Understanding Investments: Assets, Liabilities, and the Role of Financial Markets, Study Guides, Projects, Research of Investment Theory

Download Understanding Investments: Assets, Liabilities, and the Role of Financial Markets and more Study Guides, Projects, Research Investment Theory in PDF only on Docsity! Chapter 01 - Investments: Background and Issues Chapter 1 Investments: Background and Issues 1. a. Cash is a financial asset because it is the liability of the federal government. b. No. The cash does not directly add to the productive capacity of the economy. c. Yes. d. Society as a whole is worse off, since taxpayers, as a group will make up for the liability. 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, 1,500 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 1,500 shares of stock for $120,000, 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. 1-1 Chapter 01 - Investments: Background and Issues 3. a. Cash $70,000 Bank loan $50,000 Computers 30,000 Shareholders’ equity 50,000 Total $100,000 Total $100,000 Ratio of real to total assets = $30,000/$100,000 = 0.30 Assets Liabilities & Shareholders’ equity b. 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 to total assets = $100,000/$100,000 = 1.0 Assets Liabilities & Shareholders’ equity c. Microsoft shares $120,000 Bank loan $50,000 Computers 30,000 Shareholders’ equity 100,000 Total $150,000 Total $150,000 Ratio of real to total assets = $30,000/$150,000 = 0.2 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 Assets Liabilities & Shareholders’ equity 1-2 Chapter 01 - Investments: Background and Issues 12. Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets. Pension funds accept funds and then invest, 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. Banks accept deposits from customers and loan those funds to businesses, or use the funds to buy securities of large corporations. 13. 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, the fact that shares can be traded in the secondary market makes the shares more attractive to investors since investors know that, when they wish to, 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. 14. Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value. 15. With a “top-down” investment strategy, 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. 1-5 Chapter 01 - Investments: Background and Issues With a “bottom-up” investment strategy, you try to benefit from identifying undervalued securities. The disadvantage is that you tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with your level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, your analysis may be incorrect, in which case you will have fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy. 16. You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would 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. Odds are that the only one getting rich from the book is its author. 1-6