4605 Chapter 1 Problems

Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigation agency problems, that is, potential conflicts of interest between managers and shareholders. - Fixed Salary - Stock in the firm that must be held for 5 years - A salary linked to the firms profits

- A fixed salary o A fixed salary means 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, 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. - Stock in the firm that must be held for 5 years o 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 manager's career is already linked to the firm. This undiversified exposure would be exacerbated with a large stock position in the firm. - A salary linked to the firms profits o When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the firm's success. However, this may also lead to earnings 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.

What are agency problems? What are some approaches to solving them?

- Agency problems are conflicts of interest between managers and stockholders. They can be addressed through corporate governance mechanisms, such as the design of executive compensation, oversight by the Board, and monitoring from the institutional investors.

What is the difference between asset allocation and security selection?

- Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each asset class.

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

- 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 typically pays a specified cash flow at pre-contracted time intervals until the last payment on the maturity date. Equity has an indefinite life.

How does investment banking differ from commercial banking?

- Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue. Commercial banks accept deposits and lend the money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some commercial banks started transforming to "universal banks" which provide the services of both commercial banks and investment banks. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially restored via the Volker Rule.

What are the differences between real and financial assets?

- Real assets have productive capacity; they are assets used to produce goods and services. Financial assets are claims on real assets or the income generated by them.

What is the difference between a primary asset and a derivative asset?

- The primary asset has a claim on the real assets of a firm, whereas a derivative asset provides a payoff that depends on the prices of a primary asset but does not include the claim on the real assets.

Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy. (Real Estate as a Real Asset)

a. Has the stock of real assets of the economy changed? o No. The real estate in existence has not changed, only the perception of its value has. b. Are individuals less wealthy? o 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. Can you reconcile your answers to (a) and (b)? o 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.

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?

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. o The bank loan is a financial liability for Lanni. Lanni's $50,000 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. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software. o The cash paid by Lanni (both the loan and its own cash) 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 product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the form of 1,000 shares of Microsoft stock. o Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni receives a financial asset, 1,000 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, this would constitute the creation of new financial asset. d. Lanni sells the shares of stock for $140 per share and uses part of the proceeds to pay off the bank loan. o In selling 1,000 shares of stock for $140,000, 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.

Reconsider Lanni products from Problem 9 a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of real assets to total assets? b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software product. What is the ratio of real assets to total assets? c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft. What is the ratio of real assets to total assets?

a. Ratio of real to total assets = 30,000/100,000 = 0.3 b. Ratio of real to total assets = 100,000/100,000= 1.0 c. Ratio of real to total assets = 30,000/155,000 = 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.

For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction?

a. Toyota takes out a bank loan to finance the construction of a new factory. 1. Toyota creates a real asset—the factory. The loan is a financial asset that is created in the transaction. b. Toyota pays off its loan. 1. When the loan is repaid, the financial asset is destroyed but the real asset continues to exist. c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare auto parts. 1. The cash is a financial asset that is traded in exchange for a real asset, inventory.

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?

o Even if an individual investor has the expertise and capability to monitor and improve the managers' performance, the payoffs would not be worth the effort, since his ownership in a large corporation is so small compared to that of institutional investors. For example, if the individual investor owns $10,000 of IBM stock and can increase the value of the firm by 5%, a very ambitious goal, the benefit would only be: $10,000 x 5% = $500. o In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake in making sure the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm.

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?

o Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm's investment projects. For example, if the stock price rises considerably, managers might conclude that the market believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business. o In addition, the fact that shares can be traded in the secondary market makes the shares more attractive to investors since they know that, when they wish to, they will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering, and thus improves the terms on which firms can raise money in the equity market.

Give an example of three financial intermediaries and explain how they act as a bridge between small investors and large capital markets or corporations.

o Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets. o 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. o Venture capital firms pool the funds of private investors and invest in start-up firms. Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations.

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?

o 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. o 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.

What reforms to the financial system might reduce its exposure to systematic risk?

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

What would you expect to be the relationship between securitization and the role of financial intermediaries in the economy? For example, what happens to the role of local banks in providing capital for mortgage loans when national markets in mortgage-backed securities become highly developed?

o Progress in securitization facilitates the shifting of default risk from the intermediates to the investors of such a security. Since the intermediates no longer bear the default risk, their role and motivation in assessing and monitoring the quality of the borrowers is mitigated. For example, when the national market in mortgage-backed securities becomes highly developed, local banks can easily sell their claims on mortgages to the issuers of mortgage-backed securities and then use the money they receive to create more mortgages because the local banks make profits both from making loans and selling loans to the issuers of mortgage-backed securities. This way the local banks are actually incentivized by the volume of the loan that they lend out, instead of by the quality of the loan, and thus they become less cautious in originating subprime mortgages.

Why would you expect securitization to take place only in highly developed capital markets?

o Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs: (1) A safe system of business laws and low probability of confiscatory taxation/regulation. (2) A well-developed investment banking industry; (3) A well-developed system of brokerage and financial transactions, and; (4) Well-developed media, particularly financial reporting.

Wall street firms have traditionally compensated their traders with a share of the trading profits they generated. How might this practice have affected traders' willingness to assume risk? What agency problem can this practice engender?

o Since the traders benefited from profits but did not get penalized by losses, they were encouraged to take extraordinary risks. Since traders sell to other traders, there also existed a moral hazard since other traders might facilitate the misdeed. In the end, this represents an agency problem.

The average rate of return on investments in large stocks have outpaced that on investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in Treasury bills?

o 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.

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?

o 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.