Chapter 01 - The Investment Setting

SOLUTIONS MANUAL
CHAPTER 1
THE INVESTMENT SETTING
Answers to Text Discussion Questions
1 How is an investment defined?
1!1 An investment is the commitment of current funds in anticipation of receiving a larger
flow of funds in the future.
" hat are the differences !etween financial and real assets?
1!" A financial asset represents a financial claim on an asset that is usuall" documented !"
some form of legal representation such as a stoc# or !ond. A real asset is an actual
tangi!le item such as real estate$ gold$ anti%ues$ &ewels$ etc.
# 'ist some #e" areas relating to investment o!&ectives.
1!# (e" areas relating to investment o!&ectives include ris# and safet" of principal$ current
income versus capital appreciation$ li%uidit" considerations$ short-term versus long-
term orientation in measurement$ ta) factors$ ease of management$ and retirement and
estate planning considerations.
$ *)plain the concepts of direct e%uit" and indirect e%uit".
1!$ +irect e%uit" represents actual ownership of shares in a firm or the instruments that
can !e used to purchase the shares ,such as warrants or options-. Indirect e%uit" is
ownership of shares of an investment compan" that in turn owns an e%uit" position in
other firms.
% How are e%uit" and creditor claims different?
1!%. *%uit" claims represent ownership in something whereas creditor claims are
represented !" a de!t instrument.
& +o those wishing to assume low ris#s tend to invest long term or short term? h"?
1!& .is# averters tend to invest short term !ecause li%uidit" tends to !e greater and
changes in prices of assets tend to !e less over the short term.
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Chapter 01 - The Investment Setting
' How is li%uidit" measured?
1!'. 'i%uidit" is measured !" the a!ilit" to convert an asset into cash within a relativel"
short period of time with a minimum capital loss from the transaction. 'i%uidit" can
also !e measured indirectl" !" the transactions costs or commissions involved in the
transfer of ownership.
( *)plain wh" conservative investors who tend to !u" short-term assets differ
from short-term traders.
1!( Conservative investors tend to !u" short term and hold to maturit"$ and do no
necessaril" see# critical timing decisions. Short-term traders ma" !u" long or short
term$ !ut do not e)pect to hold the assets indefinitel"$ so timing to o!tain the lower
purchase price and highest selling price is critical.
) How does the Ta) .elief Act of /000 affect the relative attractiveness of long-term
capital gains versus dividend income? ,A general statement will suffice.-
1!). There is no longer a strong preference for long-term capital gains over dividends. 1oth
long-term capital gains and dividends are ta)ed at a ma)imum rate of 12 percent. This
ta) law was still in effect in /011 and /01/ !ut students might want to chec# for
revisions to the law that would affect this answer.
1* h" is there a minimum amount of time that must !e committed to an" investment
program?
1!1* *ven when someone else manages "our investments$ "ou must monitor the managers3
activities and choose the !est managers.
11 In a highl" inflationar" environment$ would an investor tend to favor real or financial
assets? h"?
1!11 .eal assets$ !ecause the" have a replacement value reflecting increasing prices. In a
more moderate inflationar" environment$ stoc#s or !onds ma" !e preferred.
1" hat two primar" components are used to measure the rate of return achieved from an
investment?
1!1" The two primar" components of return are capital gains ,or increase in value- and
current income ,for a stoc#$ this would !e represented !" dividends-.
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Chapter 01 - The Investment Setting
1# 4an" people thin# of ris# as the danger of losing mone". Is this the same wa" that ris#
is defined in finance?
1!1# In finance$ ris# is not viewed as simpl" the danger of losing mone"$ !ut rather as the
uncertaint" associated with the outcomes from an investment. The greater the
dispersion of possi!le outcomes$ the greater is the ris#.
1$ hat are the three elements that determine the return an investor should re%uire from
an investment?
1!1$ The three elements that determine re%uired return are5 the real rate of return$ the
anticipated inflation factor$ and the ris# premium.
1% *)plain how an investor receiving a / or 0 percent %uoted return in an inflationar"
environment ma" actuall" e)perience a negative real rate of return.
1!1% If the rate of inflation e)ceeds the %uoted rate of return on an investment$ the investor
will e)perience a negative real return. He or she is 6pa"ing6 the !orrower to use the
funds. 1-17. In 8igure 1-9$ the I!!otson values show that the highest return categor"
was small compan" stoc#s and the lowest was :.S. Treasur" 1ills. ;ot coincidentall"$
small stoc#s had the highest ris# and Treasur" !ills the lowest ris#.
1& In 8igure 1<9$ what has !een the highest return investment categor" over the =>-"ear
period? hat has !een the lowest? Assuming ris# is measured !" the standard
deviation$ what can "ou sa" a!out the relationship of ris# to return in 8igure 1<9?
1!1& In 8igure 1-9$ the I!!otson values show that the highest return categor" was small
compan" stoc#s and the lowest was :.S. Treasur" 1ills. ;ot coincidentall"$ small
stoc#s had the highest ris# and Treasur" !ills the lowest ris#.
PRO+LEMS
R,te o- return
1 The price of the stoc# of Clar#son Corporation went from ?20 to ?27 last "ear. The firm
also paid ?/ in dividends. Compute the rate of return.
1!1 .ate of return @
1 0 1
0
,A A - +
A
+
,?27 ?20- ?/ ?7 ?/ ?B
17C
?20 ?20 ?20
+ +
= = =
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Chapter 01 - The Investment Setting
R,te o- return
" In the following "ear$ the dividend was raised to ?/./2. However$ a !ear mar#et
developed toward the end of the "ear$ and the stoc# price declined from ?27 at the
!eginning of the "ear to ?9B at the end of the "ear. Compute the rate of return or ,loss- to
stoc#holders.
1!".
,?9B ?27- ?/./2 ?B ?/./2 ?2.=2
10./=C
?27 ?27 ?27
+ +
= = =
Ris.!-ree r,te
# Assume the real rate of return in the econom" is /.2 percent$ the e)pected rate of inflation
is 2 percent$ and the ris# premium is 2.B percent. Compute the ris#-free rate ,8ormula 1-
0- and re%uired rate of return.
1!#. .is#-free rate @ ,1 D .eal rate- ,1 D *)pected rate of inflation- < 1
,1.0/2-,1.02- E 1 @ 1.0=70 E 1 @ .0=70 @ =.70C
.e%uired rate of return @ .is#-free rate D .is# premium
@ =.70C D 2.BC
@ 10.90C
Re/uire0 return
$ Assume the real return in the econom" is 9 percent. It is anticipated that the consumer
price inde) will go from /00 to /10. Shares in common stoc# are assumed to have a
re%uired return one-third higher than the ris#-free rate. Compute the re%uired return on
common stoc#.
1!$ .eal rate @ 9.0C
*)pected rate of inflation @ /10F/00 @ 1.02 or 2C
The ris#-free rate is5
,1.09-,1.02- 1 @ 1.0>/1 @ .0>/ @ >./C
The re%uired rate of return is5
>./C 1.00 @ 1/./9C
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Chapter 01 - The Investment Setting
Geo1etric return
% Sall" is reviewing the performance of several portfolios in the famil" trusts. Trust A is
managed !" all Street Investment Advisors and Trust 1 is managed !" 'aSalle Street
Investment Advisors. 1oth trusts are invested in a com!ination of stoc#s and !onds and
have the following returns5
Trust A Trust 1
Gear 1 12C 1/C
Gear / 10 12
Gear 0 -9 -/
Gear 9 /2 /0
Gear 2 -B -2
a. Calculate the annualiHed geometric and arithmetic returns over this 2-"ear period.
!. hich manager performed the !est$ and is there a significant enough difference for Sall"
to move her mone" to the winning manager?
c. *)plain the difference !etween the geometric and arithmetic returns.
1!% a- Ieometric return @ 1
Ieometric return of Trust A @
@ 7.>1C
Ieometric return of Trust 1 @ 1
@ =.22C

Arithmetic return @
Arithmetic return of Trust A @ @ =.70C
Arithmetic return of Trust 1 @ @ BC
!- Trust 1 performed the !est as !oth the geometric return and arithmetic return of Trust 1
are !etter than those of Trust A.
e have to consider whether the two portfolios have e%ual ris# and not &ust consider the
return. The Standard deviation is a measure of the ris# and the standard deviation @ .
The standard deviation of Trust A is 10.71 and the standard deviation of Trust 1 is 10.>0.
Thus the standard deviation of Trust 1 is lower than Trust A$ which means Trust 1
provided a !etter return with a lower ris#. So there is a significant enough difference for
Sall" to move her mone" to the Trust 1.
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Chapter 01 - The Investment Setting
c- The arithmetic mean return !est represents the mean return in a single period and has an
upward !ias when negative returns are included in the return series. The geometric mean
return !est represents the compound rate of return and does not provide an" upward !ias
when negative num!ers are included in the return series. The geometric mean is the most
accurate method for determining investment returns.

C,2it,3 ,sset 2ricin4 1o0e3
& Calculate the re%uired rate of return for Camp!ell Corp. common stoc#. The stoc# has a
!eta of 1.0 and Camp!ell is considered a large capitaliHation stoc#. Current long-term
government !onds are "ielding 2.0C. ,.efer to ta!le 1-0 for e%uit" ris# premiums of
large stoc#s-.
8or CAA4$ the re%uired rate of return @ .is#-free rate D 1eta J *%uit" .is# premium
:sing Ta!le 1-0 for historical e%uit" ris# premiums we find an e%uit" ris# premium of 9.9C
when long-term government !onds are compared to large common stoc# returns.

The re%uired rate of return for Camp!ell Corp. @ 2.0C D 1.0J9.9C @ >.>=C
a. How would "our re%uired rate of return change if "ou used :.S. Treasur" !ills for "our
ris#-free rate? Assume the current "ield on T-!ills is 1./2 percent. This is an artificiall"
low rate !ecause the 8ederal .eserve is tr"ing to stimulate the econom" out of a recession.
1!& a-
The ris#-free rate changes from 2.0C to 1./2C so the mar#et ris# premium changes from
9.9C to 7.1C. So the re%uired rate of return for Camp!ell Corp. is ,1./2CD1.0J7.1C- @
>.1BC.
!. How would this difference in re%uired returns affect the value of an" cash flow "ou would
evaluate?

1!& !-
The re%uired rate of return for Camp!ell Corp decreases from >.>=C to >.1BC if we use
the current "ield on T-!ills instead of the "ield to maturit" on long-term government
!onds. The decrease in the re%uired rate of return will increase the value of an" cash flow
we would evaluate when we use the re%uired rate of return to discount future cash flows.
C,2it,3 ,sset 2ricin4 1o0e3
' 8astchip is a small technolog" compan" with a !eta of 1.2 and a mar#et capitaliHation of
?/00 million. Currentl"$ long-term government securities are "ielding 2.0 percent$
intermediate governments are "ielding 9.0 percent$ and T-!ills are "ielding 0.0 percent.
Calculate the re%uired rate of return using all three ris#-free rates. Choose which one would
!e the most aggressive and which would !e the most conservative to use in valuing cash
flows. hich would "ou prefer to use$ and wh"? ,.efer to Ta!le 1-0 for e%uit" ris#
premiums using the small stoc# returns-.
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Chapter 01 - The Investment Setting
8or CAA4$ the re%uired rate of return @ .is#-free rate D 1eta J *%uit" .is# premium
Choosing the long-term government securities "ield 2.0C as the ris#-free rate$
The re%uired rate of return for 8astchip @ 2.0CD1.2J7.2C @ 19.=2C
Choosing the intermediate governments "ield 9.0C as the ris#-free rate$ so the e%uit" ris#
premium is 9.2C$
The re%uired rate of return for 8astchip @ 9.0CD1.2J7.7C @ 10.>C
Choosing the T-!ills "ield 0.0C as the ris#-free rate$ so the e%uit" ris# premium is 7.1C$
The re%uired rate of return for 8astchip @ 0.0CD1.2JB./C @ 12.7C
is 10.>C and has the lowest re%uired rate of return so it would !e the most aggressive
and create the highest value. is 12.7C and has the highest re%uired rate of return so it
would !e the most conservative and create the lowest value of the cash flows.
If the investor wanted to !e conservative in his or her valuation of the compan" would
generate the lowest value. Kne possi!le lesson to learn is that single point value estimates
ma" give a false sense of confidence in the final value. Aerhaps the investor could value the
compan" using all three re%uired returns and generate a high-low-average range of values. If
the current stoc# price falls within the range of values$ it could !e fairl" priced.
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