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CHAPTER 1: THE INVESTMENT ENVIRONMENT

CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS 1. Ultimately, it is true that real assets determi e the material !ell "ei # $% a e&$ $my. Ne'ertheless, i di'iduals &a "e e%it !he %i a &ial e #i eeri # &reates e! (r$du&ts that all$! them t$ ma a#e their ($rt%$li$s $% %i a &ial assets m$re e%%i&ie tly. )e&ause "u dli # a d u "u dli # &reates %i a &ial (r$du&ts !ith e! (r$(erties a d se siti'ities t$ 'ari$us s$ur&es $% ris*, it all$!s i 'est$rs t$ hed#e (arti&ular s$ur&es $% ris* m$re e%%i&ie tly. Se&uriti,ati$ re-uires a&&ess t$ a lar#e um"er $% ($te tial i 'est$rs. T$ attra&t these i 'est$rs, the &a(ital mar*et eeds: 1. a sa%e system $% "usi ess la!s a d l$! (r$"a"ility $% &$ %is&at$ry ta.ati$ /re#ulati$ 0 +. a !ell1de'el$(ed i 'estme t "a *i # i dustry0 2. a !ell1de'el$(ed system $% "r$*era#e a d %i a &ial tra sa&ti$ s, a d0 3. !ell1de'el$(ed media, (arti&ularly %i a &ial re($rti #. These &hara&teristi&s are %$u d i 4i deed ma*e %$r5 a !ell1de'el$(ed %i a &ial mar*et. 2. Se&uriti,ati$ leads t$ disi termediati$ 0 that is, se&uriti,ati$ (r$'ides a mea s %$r mar*et (arti&i(a ts t$ "y(ass i termediaries. 6$r e.am(le, m$rt#a#e1"a&*ed se&urities &ha el %u ds t$ the h$usi # mar*et !ith$ut re-uiri # that "a *s $r thri%t i stituti$ s ma*e l$a s %r$m their $! ($rt%$li$s. As se&uriti,ati$ (r$#resses, %i a &ial i termediaries must i &rease $ther a&ti'ities su&h as (r$'idi # sh$rt1term li-uidity t$ &$ sumers a d small "usi ess, a d %i a &ial ser'i&es. 6i a &ial assets ma*e it easy %$r lar#e %irms t$ raise the &a(ital eeded t$ %i a &e their i 'estme ts i real assets. I% 6$rd, %$r e.am(le, &$uld $t issue st$&*s $r "$ ds t$ the #e eral (u"li&, it !$uld ha'e a %ar m$re di%%i&ult time raisi # &a(ital. C$ tra&ti$ $% the su((ly $% %i a &ial assets !$uld ma*e %i a &i # m$re di%%i&ult, there"y i &reasi # the &$st $% &a(ital. A hi#her &$st $% &a(ital results i less i 'estme t a d l$!er real #r$!th.

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. a.am(le.ists.CHAPTER 1: THE INVESTMENT ENVIRONMENT 7. si &e m$rt#a#e lia"ilities ha'e als$ i &reased. I additi$ . 6uture h$me$! ers as a !h$le are !$rse $%%. The l$a is Adestr$yedA i the tra sa&ti$ .??? &ash5 t$ the "a * a d #ets "a&* a $ther %i a &ial asset 4its IOU5. d. I retur . N$. =a i #i'es the real asset 4the s$%t!are5 t$ Mi&r$s$%t i e.7?? shares $% Mi&r$s$%t st$&*. The i &rease i (ri&e did $t add t$ the (r$du&ti'e &a(a&ity $% the e&$ $my. the this !$uld re(rese t the &reati$ $% e! %i a &ial assets. the 'alue $% the e-uity held i these assets has i &reased. the st$&* mar*et is still im($rta t t$ the %i a &ial ma a#er. 6$r e. &. ma a#ers mi#ht &$ &lude that the mar*et "elie'es the %irm8s %uture (r$s(e&ts are "ri#ht.???5. a d thus im(r$'es the terms $ !hi&h %irms &a raise m$ ey i the e-uity mar*et. i% the st$&* (ri&e rises &$ sidera"ly. =a i e. the &$m(leted s$%t!are. ". The "a * l$a is a %i a &ial lia"ility %$r =a i. =a i #ets a real asset. :. I% Mi&r$s$%t issues e! shares i $rder t$ (ay =a i.&ha #e %$r a %i a &ial asset. this h$usi # (ri&e "u""le !ill e'e tually "urst a d s$&iety as a !h$le 4a d m$st li*ely ta. 4=a i8s IOU is the "a *8s %i a &ial asset. =a i #i'es a %i a &ial asset 4@7?.&ha #es $ e %i a &ial asset 41. N$ %i a &ial assets are &reated $r destr$yed0 &ash is sim(ly tra s%erred %r$m $ e (arty t$ a $ther. The e! %i a &ial asset &reated is =a i8s (r$miss$ry $te 4that is. &. This i tur ma*es i 'est$rs m$re !illi # t$ "uy shares i a (rimary $%%eri #. <.(ayers5 !ill e dure the dama#e.es. ". si &e it is retired !he (aid $%% a d $ l$ #er e.(a si$ $% the %irm8s "usi ess. shares that &a "e traded i the se&$ dary mar*et are m$re attra&ti'e t$ i itial i 'est$rs si &e they * $! that they !ill "e a"le t$ sell their shares. The st$&* (ri&e (r$'ides im($rta t i %$rmati$ a"$ut h$! the mar*et 'alues the %irm8s i 'estme t (r$9e&ts. =a i>s IOU t$ the "a *5. a. 11+ .5 The &ash =a i re&ei'es is a %i a &ial asset. 1. E'e i% the %irm d$es $t eed t$ issue st$&* i a y (arti&ular year. I additi$ . =a i tra s%ers %i a &ial assets 4&ash5 t$ the s$%t!are de'el$(ers.7?? shares $% st$&*5 %$r a $ther 4@1+?. This mi#ht "e a use%ul si# al t$ the %irm t$ (r$&eed !ith a i 'estme t su&h as a e.

??? Liabilities & Shareholders’ equity )a * l$a @ 7?.??? C 1.??? Rati$ $% real assets t$ t$tal assets C @2?.???/@1??. Ehe the (r$9e&t Ashuts d$! A a d the %irm sells it $%% %$r &ash.CHAPTER 1: THE INVESTMENT ENVIRONMENT B. F. the rati$ is: @13?.??? @1??. 6$r &$mmer&ial "a *s.??? 2?. Assets S$%t!are (r$du&tD C$m(uters T$tal DValued at &$st Rati$ $% real assets t$ t$tal assets C @1??. %i a &ial assets $ &e a#ai re(la&e real assets. Assets Mi&r$s$%t shares C$m(uters T$tal @1+?.1/@11. Geri'ati'e assets &.??? T$tal @1??.(e&ted (rimarily "e&ause the "ul* $% the "usi ess $% %i a &ial i stituti$ s is t$ ma*e l$a s0 !hi&h are %i a &ial assets %$r %i a &ial i stituti$ s.???/@17?. 1?. a.72B/@+:.??? T$tal @1??.2? Assets ".??? Shareh$lders> e-uity 7?.BF7.7<+ C ?. the rati$ is: @1+.??? C$m(uters 2?. 112 .??? Liabilities & Shareholders’ equity )a * l$a @ 7?.? &.3<1F The di%%ere &e sh$uld "e e.??? @ <?.??? T$tal @1??.??? T$tal @17?.??? C ?.??? C ?.??? 2?.??? Shareh$lders> e-uity 7?.??? Rati$ $% real assets t$ t$tal assets C @2?.??? Shareh$lders> e-uity 1??. a. it has a hi#h rati$ $% real assets t$ t$tal assets.??? @17?. it is &hara&teri.??? )a * l$a @ 7?.?11B 6$r $ 1%i a &ial %irms.1 C ?.+? C$ &lusi$ : !he the %irm starts u( a d raises !$r*i # &a(ital.???/@1??. I 'est$rs !h$ !ish t$ h$ld #$ld !ith$ut the &$m(li&ati$ a d &$st $% (hysi&al st$ra#e.ed "y a l$! rati$ $% real assets t$ t$tal assets. Primary1mar*et tra sa&ti$ ". Ehe it is i %ull (r$du&ti$ . Liabilities & Shareholders’ equity Cash @ <?.

a&er"ated !ith a lar#e st$&* ($siti$ i the %irm. a "a * that has a multimilli$ 1d$llar l$a $utsta di # t$ the %irm has a "i# sta*e i ma*i # sure that the %irm &a re(ay the l$a . a ma a#er !h$se salary is tied t$ sh$rt1term (r$%its !ill "e ris* see*i #. "ear the l$sses as !ell as the #ai s $ the (r$9e&t. I% st$&* &$m(e sati$ is $'erd$ e. )a *s a&&e(t de($sits %r$m &ust$mers a d l$a th$se %u ds t$ "usi esses. Pe si$ %u ds a&&e(t %u ds a d the i 'est. the ma a#er mi#ht 'ie! it as $'erly ris*y si &e the ma a#er>s &areer is already li *ed t$ the %irm. 12.??? C @7?? I &$ trast. This salary stru&ture d$es $t tie the ma a#er>s immediate &$m(e sati$ t$ the su&&ess $% the %irm. the ma a#er mi#ht 'ie! this as the sa%est &$m(e sati$ stru&ture a d there%$re 'alue it m$re hi#hly. a 'ery am"iti$us #$al. 113 . A salary that is (aid i the %$rm $% st$&* i the %irm mea s that the ma a#er ear s the m$st !he the shareh$lders> !ealth is ma. h$!e'er. si &e the $! ershi( share i a lar#e &$r($rati$ !$uld "e 'ery small. a d there"y i &rease the 'alue $% the %irm. Ve ture &a(ital %irms ($$l the %u ds $% (ri'ate i 'est$rs a d i 'est i start1u( %irms. E'e i% a i di'idual shareh$lder &$uld m$ it$r a d im(r$'e ma a#ers> (er%$rma &e. $ "ehal% $% &urre t a d %uture retirees. a d mi#ht "e less !illi # t$ assume that ris*. i the ati$ al a d i ter ati$ al se&urities mar*ets. a d this u di'ersi%ied e. $r use the %u ds t$ "uy se&urities $% lar#e &$r($rati$ s. $ "ehal% $% these i 'est$rs. Mutual %u ds a&&e(t %u ds %r$m small i 'est$rs a d i 'est. ". The l$!er a'era#e rate $% retur &$m(ared t$ st$&*s is the (ri&e i 'est$rs (ay %$r (redi&ta"ility $% i 'estme t (er%$rma &e a d ($rt%$li$ 'alue. This stru&ture is there%$re m$st li*ely t$ ali# the i terests $% ma a#ers a d shareh$lders. 6i'e years $% 'esti # hel(s ali# the i terests $% the em(l$yee !ith the l$ #1term (er%$rma &e $% the %irm. i &$ trast. A %i. H$!e'er. a. Treasury "ills ser'e a (ur($se %$r i 'est$rs !h$ (re%er a l$!1ris* i 'estme t.??? $% 6$rd st$&* a d &a i &rease the 'alue $% the %irm "y 7H. It is &learly !$rth!hile %$r the "a * t$ s(e d &$ sidera"le res$ur&es t$ m$ it$r the %irm.imi. Shareh$lders.ed salary mea s that &$m(e sati$ is 4at least i the sh$rt ru 5 i de(e de t $% the %irm8s su&&ess. there"y &ha eli # %u ds %r$m $ e se&t$r $% the e&$ $my t$ a $ther.CHAPTER 1: THE INVESTMENT ENVIRONMENT 11.ed. i% y$u $! @1?. 6$r e. H$!e'er. es(e&ially i% these sh$rt1term (r$%its determi e salary $r i% the &$m(e sati$ stru&ture d$es $t "ear the %ull &$st $% the (r$9e&t>s ris*s. 1+. 13.($sure !$uld "e e. the (ay$%% !$uld "e small.?7 × @1?. A (r$%it1li *ed salary &reates #reat i &e ti'es %$r ma a#ers t$ &$ tri"ute t$ the %irm>s su&&ess.am(le. &. y$u "e e%it "y $ ly: ?.

t$(1d$! ma a#eme t is the atural !ay t$ esta"lish a ($rt%$li$ !ith a le'el $% ris* &$ siste t !ith y$ur ris* t$lera &e. !hi&h may result i a $ 1di'ersi%ied ($rt%$li$ $r a ($rt%$li$ !ith a ris* le'el i &$ siste t !ith y$ur le'el $% ris* t$lera &e. The disad'a ta#e is that y$u te d t$ $'erl$$* the $'erall &$m($siti$ $% y$ur ($rt%$li$. stude ts sh$uld t$u&h $ the %$ll$!i #: i &reased tra s(are &y. i !hi&h &ase y$u !ill ha'e %ruitlessly e.$u sh$uld "e s*e(ti&al. "y &$ trast. I additi$ .(e&ted retur s re-uire "eari # s$me ris*. Shareh$lders. i &e ti'es t$ dis&$ura#e e. 6i a &ial assets (r$'ide %$r a mea s t$ a&-uire real assets as !ell as a e. are a%%e&ted dire&tly "y "$th the u(side a d d$! side ($te tial $% ris*. 6i a &ial assets (r$'ide a measure $% li-uidity t$ real assets a d all$! %$r i 'est$rs t$ m$re e%%e&ti'ely redu&e ris* thr$u#h di'ersi%i&ati$ . Eith a It$(1d$! J i 'esti # style. Odds are that the $ ly $ e #etti # ri&h %r$m the "$$* is its auth$r. The disad'a ta#e $% a exclusive em(hasis $ t$(1d$! issues is that y$u may %$r%eit the ($te tial hi#h retur s that &$uld result %r$m ide ti%yi # a d &$ &e trati # i u der'alued se&urities $r se&t$rs $% the mar*et. M$re$'er. !hi&h is the ma9$r determi a t $% $'erall (er%$rma &e. 1B. 117 . y$ur a alysis may "e i &$rre&t.(a si$ $% these real assets. Eith a I"$tt$m1u(J i 'esti # style. h$!e'er. 6i ally. y$u %$&us $ asset all$&ati$ $r the "r$ad &$m($siti$ $% the e tire ($rt%$li$. 6i a &ial mar*ets are 'ery &$m(etiti'e0 $ e $% the im(li&ati$ s $% this %a&t is that ri&hes d$ $t &$me easily. All$!i # traders t$ share i the (r$%its i &reases the traders> !illi # ess t$ assume ris*. . a d $"'i$us "ar#ai s are %e! a d %ar "et!ee . 1:. $ e must -uesti$ !hy the auth$r !$uld the "e s$ ready t$ sell the se&ret t$ $thers. y$u try t$ "e e%it %r$m ide ti%yi # u der'alued se&urities. Traders !ill share i the u(side ($te tial dire&tly "ut $ ly i the d$! side i dire&tly 4($$r (er%$rma &e C ($te tial 9$" l$ss5. Hi#h e.(e ded e%%$rt a d m$ ey attem(ti # t$ "eat a sim(le "uy1a d1h$ld strate#y. this te&h i-ue te ds t$ re-uire m$re a&ti'e ma a#eme t.CHAPTER 1: THE INVESTMENT ENVIRONMENT 17. a d the (r$m$ti$ $% m$re a&&urate a d u "iased ris* assessme t. A s!ers may 'ary. I% the auth$r a&tually * $!s h$! t$ a&hie'e su&h retur s. 1F. 1<. thus #e erati # m$re tra sa&ti$ &$sts. re#ulati$ s t$ (r$m$te &a(ital ade-ua&y "y i &reasi # the %re-ue &y $% #ai $r l$ss settleme t.&essi'e ris* ta*i #.