Answers to Selected Problems PDF receives a financial asset 5

Answers to Selected Problems

receives a financial asset 5

Answers to Selected Problems

Chapter 1

1. (1.9)

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, 5,000 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 5,000 shares of stock for $125,000, 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.

2. (1.10)

Cash$70,000 Bank loan$50,000

Computers30,00050,000

Total$100,000 Total$100,000

Assets

Liabilities &

Ratio of real to total assets =

000,100$

000,30$

= 0.3 b.

Software product*$70,000 Bank loan$50,000

Computers30,00050,000

Total$100,000 Total$100,000

*Value at cost

Assets

Liabilities &

Ratio of real to total assets =

000,100$

= 1.0 2 c.

Microsoft shares$125,000 Bank loan$50,000

Computers30,000105,000

Total$155,000 Total$155,000

Assets

Liabilities &

Ratio of real to total assets =

000,155$

000,30$

= 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, the percentage of real assets to total assets goes down again because the product is again exchanged into financial assets. (1.11)

3. Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act

proposes several mechanisms to mitigate systemic risk. The act attempts to limit the risky activities in which the banks can engage and calls for stricter rules for bank capital, liquidity, and risk management practices, especially as banks become larger and their potential failure becomes more threatening to other institutions. The act seeks to unify and clarify the lines of regulatory authority and responsibility in government agencies and to address the incentive issue by forcing employee compensation to reflect longer-term performance. It also mandates increased transparency, especially in derivatives markets. (1.12)

4. For commercial banks, the ratio is:

3.157,12$

0.157$

= 0.0129

For non-financial firms, the ratio is:

196,28$

661,13$

= 0.4845 The difference should be expected since the business of financial institutions is to make loans that are financial assets. 3 (1.13)

5. National wealth is a measurement of the real assets used to produce GDP in the economy.

Financial assets are claims on those assets held by individuals. Financial assets owned by households represent their claims on the real assets of the issuers, and thus show up as wealth to households. Their interests in the issuers, on the other hand, are obligations to the issuers. At the national level, the financial interests and the obligations cancel each other out, so only the real assets are measured as the wealth of the economy. The financial assets are important since they drive the efficient use of real assets and help us allocate resources, specifically in terms of risk return trade-offs.

6. (1.14)

a. A fixed salary means compensation is (at least in the short run) independent of the compensation to the success of the firm, and thus allows the manager to envision and seek the sustainable operation of the company. However, since the compensation is secured and not tied to the performance of the firm, the manager might not be motivated to take any risk to maximize the value of the company. b. A salary paid in the form of stock in the firm means the manager earns the most when shareholder wealth is maximized. When the stock must be held for five years, the manager has less of an incentive to manipulate the stock price. This structure is most likely to align the interests of managers with the interests of the shareholders. If stock compensation is used too much, the manager might view it as overly risky since the exacerbated with a large stock position in the firm. c. When executive salaries are linked to firm profits, the firm creates incentives for manipulation or accounting fraud, such as divestment of its subsidiaries or unreasonable revenue recognition. That is what audits and external analysts will look out for. 4

Chapter 2

(2.12) 1. liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs. (2.13)

2. Equivalent taxable yield =

炼7D[UDWH =

10.38%

(2.14)

3. After-tax yield = Rate on the taxable bond x (1 炼 Tax rate)

a. The taxable bond. With a zero tax bracket, the after-tax yield for the taxable bond is the same as the before-tax yield (5%), which is greater than the 4% yield on the municipal bond. b. The taxable bond. The after-tax yield for the taxable bond is: 0.05 x (1 0.10) =

0.045 or 4.50%.

c. Neither. The after-tax yield for the taxable bond is: 0.05 x (1 0.20) = 0.4 or 4%. The after-tax yield of taxable bond is the same as that of the municipal bond. d. The municipal bond. The after-tax yield for the taxable bond is: 0.05 x (1 0.30) = 0.035 or 3.5%. The municipal bond offers the higher after-tax yield for investors in tax brackets above 20%. (2.15)

4. The after-tax yield on the corporate bonds is: 0.09 x (1 0.30) = 0.063 or 6.3%.

Therefore, the municipals must offer at least 6.3% yields. (2.16)

5. Using the formula of Equivalent taxable yield (r) =

炼 , we get: 炼 = 0.04 or 4.00% 5

6. (2.17)

a. You would have to pay the asked price of:

98 = 98% of par = $980.00

b. The coupon rate is 4.25%, implying coupon payments of $42.5 annually or, more precisely, $21.25 (= 42.5/2) semiannually. c. Given the asked price and coupon rate, we can calculate current yield with the formula:

Current yield =

0"... = 4.25/98 = 0.0434 = 4.34%

7. (2.18)

a. The closing price today is $75.60, which is $0.97 above b. You would buy 66 shares: $5,000/$75.60 = 66.14. c. Your annual dividend income on 66 shares would be 66 x $1.88 = $124.08. d. Earnings per share can be derived from the price-earnings (PE) ratio: Given price/Earnings = 10.92 and Price = $75.60, we know that Earnings per

Share = $75.60/10.92 = $6.92.

8. (2.19)

a. At t = 0, the value of the index is: ($90 + $50 + $100)/3 = 80 At t = 1, the value of the index is: ($95 + $45 + $110)/3 = 83.33

The rate of return is:

炼 1 = (83.33/80) 1 = 0.0417 or 4.17% b. In the absence of a split, stock C would sell for $110, and the value of the index would be the average price of the individual stocks included in the index: ($95 + $45 + $110)/3 = $83.33. After the split, stock C sells at $55; however, the value of the index should not be affected by the split. We need to set the divisor (d) such that:

83.33 = ($95 + $45 + $55)/d

d = 2.34 c. The rate of return is zero. The value of the index remains unchanged since the return on each stock separately equals zero. 6

9. (2.20)

a. Total market value at t = 0 is: ($90 x 100) + ($50 x 200) + ($200 x 100) = $39,000

Total market value at t = 1 is:

($95 x 100) + ($45 x 200) + ($110 x 100) = $40,500

Rate of return =

炼 1 = ($40,500/$39,000) 1 = 0.0385 or 3.85% b. The return on each stock is as follows: RA = 炼 1 = ($95/$90) 1 = 0.0556 or 5.56% RB = 炼 1 = ($45/$50) 1 = 0.10 or 10.00% RC = 炼 1 = ($110/$100) 1 = 0.10 or 10.00% The equally-weighted average is: [5.56% + (10.00%) + 10.00%]/3 = 1.85% (2.21)

10. The fund would require constant readjustment since every change in the price of a stock

would bring the fund asset allocation out of balance. (2.22)

11. In this case, the value of the divisor will increase by an amount necessary to maintain the

index value on the day of the change. For example, if the index was comprised of only one stock, it would increase by 2.06 points: ($95 $31) / $31 = 2.06. CFA 1

Answer: c. Taxation

Chapter 3

1. (3.15)

a. The stock is purchased for $40 300 shares = $12,000. Given that the amount borrowed from the broker is $4,000, Dees margin is the initial purchase price net borrowing: $12,000 $4,000 = $8,000. b. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the year, the amount of the loan owed to the broker grows to: Principal (1 + Interest rate) = $4,000 (1 + 0.08) = $4,320. The value of the stock falls to: $30 300 shares = $9,000. T

Margin on long position = DFFRXQW

9DOXHRIVWRFN

= 0.52 = 52% Therefore, the investor will not receive a margin call. c. Rate of return = HTXLW\LQDFFRXQW炼,QLWLDOHTXLW\LQDFFRXQW ,QLWLDOHTXLW\LQDFFRXQW = 0.4150 = 41.50%

2. (3.16)

a. The initial margin was: $40 x 1,000 0.50 = $20,000. As a result of the $10 increase in the stock price, Old Economy Traders loses: $10

1,000 shares = $10,000.

Moreover, Old Economy Traders must pay the dividend of $2 per share to the lender of the shares: $2 1,000 shares = $2,000. The remaining margin in the investors account therefore decreases to: $20,000 $10,000 $2,000 = $8,000. b. Margin on short position =

9DOXHRIVKDUHVRZHG

VKDUHV = 0.16 = 16% Because the percentage margin falls below the maintenance level of 30%, there will be a margin call. 8 c. The rate of return = HTXLW\炼,QLWLDOHTXLW\ ,QLWLDOHTXLW\ = ---炼 Dtrquotesdbs_dbs35.pdfusesText_40

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