FIN 128 Topic 1 HW questions

1. What are the differences between equity and fixed-income securities?

1. Equity is a lower-priority claim and represents an ownership share in a corporation, whereas fixed-income (debt) security is a higher-priority claim but does not have an ownership interest. Fixed-income (debt) security pays a specified cash flow at pre-contracted time intervals until the last payment on the maturity date. Equity has an indefinite life.

13. Why do financial assets show up as a component of household wealth, but not of national wealth? Why do financial assets still matter for the material well-being of an economy? (LO 1-2)

13. 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.

21. The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by about 7% since 1926. Why, then, does anyone invest in Treasury bills? (LO 1-1)

21. 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.

22. You see an advertisement for a book that claims to show how you can make $1 million with no risk and with no money down. Will you buy the book? (LO 1-1)

22. 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 this book is its author.

5. What are the differences between real and financial assets? (LO 1-2)

5. Real assets are assets used to produce goods and services. Financial assets are claims on real assets or the income generated by them.

7. For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction? (LO 1-2) a. Toyota takes out a bank loan to finance the construction of a new factory. b. Toyota pays off its loan. c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare auto parts.

7. a. Toyota creates a real asset—the factory. The loan is a financial asset that is created in the transaction. b. When the loan is repaid, the financial asset is destroyed but the real asset continues to exist. c. The cash is a financial asset that is traded in exchange for a real asset, inventory.

8. Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy. (LO 1-2) a. Has the stock of real assets of the economy changed? b. Are individuals less wealthy? c. Can you reconcile your answers to ( a ) and ( b )?

8. a. No. The real estate in existence has not changed, only the perception of its value has. b. Yes. The financial asset value of the claims on the real estate has changed, and thus the balance sheet of individual investors has been reduced. c. The difference between these two answers reflects the difference between real and financial asset values. Real assets still exist, yet the value of the claims on those assets or the cash flows they generate do change. Thus, there is the difference.

9. Lanni Products is a start-up 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? (LO 1-2) a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay back the loan over three years. b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software. 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 5,000 shares of Microsoft stock. d. Lanni sells the shares of stock for $25 per share and uses part of the proceeds to pay off the bank loan.

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.