BKM Ch 01 Answers

BKM CHAPTER 1: THE INVESTMENT ENVIRONMENT 1. Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue  that resources used for rearranging wealth (that is, bundling and unbundling financial assets)  might be better spent on creating wealth (that is, creating real assets). Evaluate this criticism. Are any benefits realized by creating an array of derivative securities from various primary  securities? Over time, traditional financial assets such as stocks, bonds and mortgages have developed specific  types of payment patterns, risks and returns.  For example, government bonds have semi­annual  coupons so the bond holder incurs reinvestment risk if the coupon income is not spent.  Mortgage loans  have a prepayment option so the mortgage lender risks the return of the loan principal when rates  decrease.  Almost all debt contracts incur the risk that the borrower will not repay the loan (default or  credit risk). Financial engineering allows for a change in the risk and return patterns of traditional securities.   Treasury Strips, for example, allow lending money to the US government without incurring  reinvestment risk.  Mortgage backed securities allow for lending money to home buyers with lower  (possibly zero) prepayment and default risks. These financially engineered products, which are claims on a large pool of underlying assets, may be  worth more than the value of the underlying assets due to the redistribution of the risks. 2. Why would you expect securitization to take place only in highly developed capital markets? Securitization requires access to a large number of potential investors.  To attract these investors, the  capital market needs: (1) (2) (3) (4)

a safe system of business laws and low probability of confiscatory taxation/regulation a well­developed investment banking industry a well­developed system of brokerage and financial transactions well­developed media, particularly financial reporting

These characteristics are found in (and a necessary for) a well­developed financial market. 3. What is the relationship between securitization and the role of financial intermediaries in the  economy? What happens to financial intermediaries as securitization progresses? Securitization leads to disintermediation. Securitization provides a means for market participants to  bypass intermediaries such as banks.  For example, mortgage­backed securities channel funds to the  housing market through mortgage brokers without requiring that banks or thrift institutions make  loans from their own portfolios.   As securitization progresses, financial intermediaries must increase other activities such as providing  short­term lending or other financial services which cannot be easily securitized to consumers and  small business.

1

4. Although we stated that real assets comprise the true productive capacity of an economy, it is  hard to conceive of a modern economy without well­developed financial markets and security  types. How would the productive capacity of the U.S. economy be affected if there were no  markets in which one could trade financial assets?  Financial assets make it easy for commercial firms to raise the capital needed to finance investments  in (buy) real assets.  If General Electric could not issue stocks or bonds to the public, it would have a  far more difficult time raising capital pay for new projects.  The inability to use public financial assets would make financing more difficult (costly), thereby increasing the cost of capital to a business.  A  higher cost of capital results in less investment and slower real growth. 5. Firms raise capital from investors by issuing shares in the primary markets. Does this imply  that corporate financial managers can ignore trading of previously issued shares in the  secondary market?  Secondary markets increase the liquidity of a company's securities.  Investors require a return  premium to hold illiquid securities.  For example, an investor may require 5.00% return on a  company’s bonds if the bond is highly liquid (if the bond could be sold immediately in the secondary  market without a drop in price).  But the investor might require a return of 5.25% to hold an illiquid  bond.  The extra 25 basis points (0.25%) liquidity premium required by the investor is a cost born by  the company issuing the bond (borrowing the money) in the form of higher coupon payments.   Shares of a company’s stock entitle the investor to percentage of the earnings ­ either paid as  dividends or retained by the company for the investors benefit. If the investor cannot easily sell the  stock (if the stock is illiquid) the investor will pay less for the same percent­ownership of the  company.  Therefore, if the company wants to issue new shares to raise a fixed amount of money, it  will have to sell more lower­priced shares to raise that fixed amount.    7. Lanni Products is a start­up computer software development firm. It currently owns computer  equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni's owners. For  each of the following transactions, identify the real and/or financial assets that trade hands. Are  any financial assets created or destroyed in the transaction? (a) Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay  back the loan over 3 years. The bank loan is a financial liability or debt for Lanni.  Lanni's IOU is a new financial asset for the  bank. The cash Lanni receives is also a financial asset.   (b) Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software. Lanni transfers the financial asset (cash) to the software developers. In return, Lanni gets a real asset, the completed software. No financial assets are created or destroyed; cash is simply transferred from one party to another. (c) Lanni sells the software product to Microsoft, which will market it to the public under the  Microsoft name. Lanni accepts payment in the form of 1,500 shares of Microsoft stock.

2

Lanni gives the real asset (the software) to Microsoft in exchange for a financial asset, 1,500 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, then this would represent the creation of new financial assets and dilute the ownership stake of Microsoft’s existing shareholders. (d) Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the bank loan. Lanni exchanges one financial asset (1,500 shares of stock) for another ($120,000 in cash). Lanni gives a financial asset ($50,000 cash) to the bank and ends a financial asset (its IOU to the bank). The loan is "destroyed" in the transaction, since it is retired when paid off. 9. Examine the balance sheet of commercial banks in Table 1.3. What is the ratio of real assets to  total assets? What is that ratio for nonfinancial firms (Table 1.4)? Why should this difference be  expected? For commercial banks, the ratio is: $140.1/$11,895.1 = 1.18% For non-financial firms, the ratio is: $12,538/$26,572 = 47.19% The difference is expected. A financial institutions’ business is to make loans, which are financial assets for financial institutions. 11. Discuss the advantages and disadvantages of the following forms of managerial compensation in  terms of mitigating agency problems, that is, potential conflicts of interest between managers and  shareholders. (a) A fixed salary. A fixed salary means that compensation is (at least 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.  However, the manager might view this as the safest compensation structure and therefore  value it more highly.  (b) Stock in the firm that must be held for five years. 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. This structure is therefore most likely to align the interests of managers and shareholders. If stock compensation is overdone, however, the manager might view 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 salary linked to the firm's profits. Call options on shares of the firm create great incentives for managers to contribute to the firm’s success. In some cases, however, stock options can lead to other agency problems. For example, a manager with numerous call options might be tempted to take on a very risky investment project, reasoning that if the project succeeds the payoff will be huge, while if it fails, the losses are limited

3

to the lost value of the options. Shareholders, in contrast, bear the losses as well as the gains on the project, and might be less willing to assume that risk. Another problem with stock and option compensation is the manager might sacrifice long-run profits for the short-run profits. The stock price goes up and the manager gets out. Afterwards, the stock price goes down. 12. We noted that oversight by large institutional investors or creditors is one mechanism to reduce  agency problems. Why don't individual investors in the firm have the same incentive to keep an  eye on management? The scale for individuals means the gains from influencing the firm are small. If an individual shareholder could monitor and improve managers’ performance, and thereby increase the value of the firm, the payoff would be 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. In contrast, 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. 13. Give an example of three financial intermediaries and explain how they act as a bridge between  small investors and large capital markets or corporations. Four Examples: (1) Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets. (2) 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. (3) Venture capital firms pool the funds of private investors and invest in start-up firms. (4) Banks accept deposits from customers and loan those funds to businesses, or use the funds to buy securities of large corporations. 15. What are some advantages and disadvantages of top-down versus bottom-up investing styles? (Be sure you can define both top­down and bottom­up portfolio construction or investing styles.) Top­down specifically considers risk and risk tolerance. Identification of undervalued securities is a  secondary consideration.  Identifying undervalued securities is the primary focus of a bottom­up style of portfolio construction.  A disadvantage is that it does not (primarily) consider the overall composition of the portfolio, which  may result in low diversification and higher risk or risk inconsistent with the investors risk tolerance.  In addition, bottom­up tends to require more active management, thus generating more transaction costs.  

4