Chapter 1 The Investment Environment

Essay Questions

01) Discuss the agency problem in detail.

Answer:
Managers are the agents of the shareholders and should act on their behalf to maximize shareholder
wealth (the value of the stock). A conflict (the agency conflict) arises when managers take self-
interested actions to the detriment of shareholders. The roles of the board of directors selected by
the shareholders are to oversee management and to minimize agency problems. However, often
these boards are figureheads, and individual shareholders do not own large enough blocks of the
shares to override management actions. One potential resolution of an agency problem occurs when
inefficient management actions cause the price of the stock to be depressed. The firm may then
become a takeover target. If the acquisition is successful, managers may be replaced and
potentially, stockholders' benefit.

02) Discuss the similarities and differences between real and financial assets.
Difficulty: Moderate

Answer:
Real assets represent the productive capacity of the firm and appear as assets on the firm's balance
sheet. Financial assets are claims against the firm and thus appear as liabilities on the firm's balance
sheet. On the other hand, financial assets are listed on the asset side of the balance sheet of the
individuals who own them. Thus, when financial statements are aggregated across the economy, the
financial assets cancel out, leaving only the real assets, which directly contribute to the productive
capacity of the economy. Financial assets contribute indirectly only.

03) Discuss the euro about its impact on globalization. How is it currently used, and what are the plans
for its future use?
Difficulty: Moderate

Answer:
The euro was introduced in 1999 as a new currency and has replaced the currencies of twelve
participating countries so there will be one common European currency in the participating
countries. A common currency is expected to facilitate global trade and encourage the integration of
markets across national boundaries.

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 Chapter 1 The Investment Environment

04) Discuss the following ongoing trends as they relate to the field of investments: globalization,
financial engineering, securitization, and computer networks
Difficulty: Moderate

Answer:
Globalization offers a broader array of investment choices than what would be available to
investors who could only choose domestic securities. As efficient communication technology has
become available, globalization of markets has been significantly enhanced. There are many
mechanisms by which one country's investors can hold foreign companies' securities. Some
examples are ADRs, WEBS, and direct purchase of foreign securities.

Securitization refers to aggregating underlying financial assets, such as mortgages, into pools and
then offering a security that represents a claim on these underlying assets. Examples are GNMAs.
Securitization allows investors to hold partial ownership in financial assets that would otherwise be
beyond their reach (e.g., mortgages).

Financial engineering involves bundling or unbundling. Bundling involves combining individual

Computer networks have permitted online trading, online information dissemination and
automated trade crossing. Each of these significant breakthroughs has significant implications for
investments.

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 Chapter 2 Asset Classes and Financial Investments

Essay Questions

01) Distinguish between U. S. Treasury debt and U. S Agency debt.

Answer:
Debt issued by the U. S. Treasury is backed by the full taxing power of the U. S. Treasury. Such
instruments are considered to be free of default risk. Similar to the U.S. Treasury, some agencies of
the U. S. government issue debt also. Technically, this debt is not backed by the U. S. Treasury.
However, most investors think that if any U. S. agency were having trouble meeting a debt
commitment, the U. S. Treasury would come to the rescue of the agency. Thus, as a result, U. S.
agency issues are considered almost as safe as U. S. Treasury issues and earn a yield only slightly
higher than that of U. S. Treasury issues.

02) Discuss the advantages and disadvantages of common stock ownership, relative to other investment
alternatives.
Difficulty: Moderate

Answer:
The advantages of common stock ownership are: The stockholder is allowed to participate in
earnings, that is, if the firm is doing well, these benefits are passed on to the shareholder in the form
of dividends and/or increased market price of the stock (with fixed-income investments, such as
bonds and preferred stock, the investor receives a fixed payment, regardless of the earnings of the
firm); besides, the common stock investment represents ownership in the firm, giving the
shareholder voting rights; and finally, the shareholder is liable only for the amount of the
shareholder's investment in the stock. That is, unlike a sole proprietorship or partnership, the
common stockholder has limited liability.

The disadvantages of common stock ownership are: The cash flow from dividends (if any) and the
appreciation of the stock is uncertain, the firm makes no commitment to the common shareholder
regarding future income resulting from common stock ownership; besides, the claims of the
bondholders and other creditors come before the benefits of the common shareholders; the preferred
shareholders must receive dividends before common shareholders if preferred dividends are
skipped, these dividends are cumulative and skipped preferred dividends must be paid before
common dividends are paid. Thus, the claims of the common shareholder are residual; that is, only
after all other creditors' and investors' claims have been met will the claims of the common
shareholder be honoured.

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