CHAPTER 1

THE INVESTMENT SETTING

1. Define investment. Discuss the overall purpose of investing.

Answer: An investment is a current commitment of funds for some time to obtain a future
flow of funds that will offset the investor for the time value of money, the expected rate of
inflation over the life of the investment, and provide a premium for the risk (uncertainty)
associated with this future flow of funds.

When an individual’s current income exceeds his current consumption needs, he could save
the excess funds. Instead of keeping these savings in his possession, he may consider it wise
to forego immediate holding of the money for more future consumption. This trade-off
between present consumption and a higher level of future consumption is the essence of
investment.

3. Divide a person’s life from ages 20 to 70 into 10-year segments and discuss the likely
saving or borrowing patterns during each period.

Answer: In the 20–30-year segment, an individual would tend to be a net borrower since he
is in comparatively low-income support and has various expenses -education, boarding and
lodging, durable goods, and so forth. In the 30–40-year segment, the individual would like
to dissave or borrow since his expenses would grow with the advent of family life, and most
probably, need to buy a house. In the 40–50-year segment, the individual would probably
be a saver since income would have enhanced considerably with no increase in expenses.
Between the ages of 50 and 60, the individual would typically be a solid saver since his
income would continue to increase, and by now, his children have grown up and left home.
After this, depending upon when the individual retires, he would probably be a dissever as
income drops because of moving from regular income to income from a pension.
4. Discuss why you would expect the saving-borrowing pattern to differ by occupation (for
example, for a doctor versus a plumber).

Answer: The saving-borrowing pattern would vary from profession to profession as the
compensation pattern differs. For most white-collar professions (company management,
accountants, financial jobs, consultants, computer programmers, lawyers, etc.), income
would tend to increase with age. Hence, they tend to be borrowers in the early segments
(when their income is low) and savers later in life. Alternatively, in blue-collar professions
(e.g., plumbers, workers, etc.), where skill is often physical, compensation tends to remain
constant or decline with age. So, blue-collar workers would be savers in the early segments
and dissever in later life (when their income drops).

5. The Wall Street Journal reported that the yield on common stocks is about 2 percent,
whereas a study at the University of Chicago contends that the annual rate of returns on
common stocks since 1926 have averaged about 10 percent. Reconcile these statements.
Answer: The difference is due to the meaning and measurement of return. In the case of
the Wall Street Journal, they are only referring to the current dividend yield on common
stocks versus the agreed yield on bonds. While the University of Chicago studies is talking
about the total rate of return on common stocks, which is the dividend yield plus the capital
gain or loss yield during the period. In the long run, the dividend yield and the capital gain
yield have averaged about 10 percent. Therefore, it is essential to compare alternative
investments based on total return.

6. Some financial theorists consider the variance of the distribution of projected rates of
return to be a good measure of uncertainty. Discuss the reasoning behind this measure of
risk and its purpose.

Answer: The variance of anticipated returns implies a measure of the dispersion of actual
returns around the anticipated value. The higher the variance, everything else remaining
constant, the greater the dispersion of expectations and the greater the risk/ uncertainty of
the investment. The purpose of the variance analysis is to help measure and explain the risk
 associated with a particular investment.

7. Discuss the three components of an investor’s required rate of return on investment.

Answer: The required rate of return is the minimum rate of return an investor should accept
from any investment to compensate him for delaying consumption. In other words, an
investor invests today to enjoy the benefits at a later stage.
The components of an investor’s required rate of return that could compensate him for the
risk taken are:
 The time value of money during the investment period
 The expected rate of inflation during the investment period
 The risk involved
We examine each of these components.
i. The time value of money. The idea is that money available at present is worth more than
the same amount in the future due to its potential earning capacity. For example, one may
need to determine the future value (FV) of an investment of $100,000 over 10 years
invested at a specific rate. Investors generally prefer to receive money from an
investment sooner rather than later. Money received by an investor today can be invested
to generate an additional return tomorrow. Therefore, the earlier the cash received, the
greater the potential for increasing wealth. An individual may sacrifice the use of money
for a specified time with some compensation in return.
ii. The expected rate of inflation. Inflation must be considered in any calculation to reflect
the value of the investment at a later date. It suggests the spending power of money
decreases over time due to inflation. Any lender would expect compensation for this
decline in spending power. 
iii. The risk. Compensation for the potential risk must be a subject of consideration while
determining the required rate of return on investment. Risk factors vary from one type of
instrument to another or from one environment to another. When there is a high degree of
certainty about an investment’s return, for example, in the case of treasury bills, the
premium will be low. The most fundamental principle of financial management is that the
return must be commensurate with the risk taken.
8. Discuss the two major factors that determine the market nominal risk-free rate (NRFR).
Explain which of these factors would be more volatile over the business cycle.

Two factors that influence the RFR are liquidity and the real economic growth rate.
Liquidity depends on the supply and demand of capital in the economy. The effect of
liquidity on the RFR is inverse, but the real growth rate has a positive relationship with the
RFR - i.e., the higher the real growth rate, the higher the RFR.

It is unlikely that the economy’s long-run real growth rate will change dramatically during a
business cycle. However, liquidity depends upon the government’s monetary policy and
would change depending on what the government considers to be the appropriate
stimulus. Besides, the demand for business loans would be highest during the early and
middle parts of the business cycle.

9. Briefly discuss the five fundamental factors that influence the risk premium of an
investment.
The five factors that influence the risk premium on an investment are business risk, financial
risk, liquidity risk, exchange rate risk, and country risk.
Business risk is a function of sales volatility and operating leverage. The combined effect of
these two variables can be quantified in terms of the coefficient of variation of operating
earnings. Operating leverage occurs when a firm has fixed costs that are to be met
regardless of sales volume.
Financial risk is a function of the uncertainty introduced by the financing mix. The inherent
risk involved in the inability to meet future contractual payments, such as interest on bonds,
etc., or the threat of bankruptcy.
Financial risk is measured in terms of a debt ratio (e.g., debt/equity ratio) and/ or the
interest coverage ratio.
Liquidity risk is the uncertainty an individual faces when he decides to buy or sell an
investment. The two uncertainties involved are: (1) how long it will take to buy or sell this
 asset, and (2) what price will be received. The liquidity risk on different investments can
vary substantially (e.g., real estate vs. T-bills).
Exchange rate risk is the uncertainty of returns on securities acquired in a different
currency. The exchange rate risk is caused by fluctuations in the investor's local currency
compared to the foreign-investment currency. The risk applies to the global investor or
multinational corporate manager who must anticipate returns on securities in light of
uncertain future exchange rates. A good measure of this uncertainty would be the absolute
volatility of the exchange rate or its beta with a composite exchange rate.
Country risk is the uncertainty of returns caused by the possibility of a major change in the
political or economic environment of a country. The analysis of country risk is much more
subjective and must be based on the history and current environment in the country.

10. You own stock in the Gentry Company and you read in the financial press that a recent
bond offering has raised the firm’s debt/equity ratio from 35 percent to 55 percent.
Discuss the effect of this change on the variability of the firm’s net income stream, other
factors being constant. Discuss how this change would affect your required rate of return
on the common stock of the Gentry Company.

Answer: The increased use of debt increases the fixed interest payment. Since this fixed
contractual payment will increase, the residual earnings (net income) will become more
variable. The required rate of return on the stock will change since the financial risk (as
measured by the debt/equity ratio) has increased.

11. Draw a properly labeled graph of the security market line (SML) and indicate where
you would expect the following investments to fall along that line. Discuss your
reasoning.
a. Common stock of large firms
b. U.S. government bonds
c. U.K. government bonds
d. Low-grade corporate bonds
e. Common stock of a Japanese firm

Answer:

NRFR
12. Explain why you would change your nominal required rate of return if you expect the
rate of inflation to go from 0 (no inflation) to 4 percent. Give an example of what would
happen if you do not change your required rate of return under these conditions

Answer: If a market’s real RFR is, say, 3 percent, the investor will require a 3 percent return on
investment since this will compensate him for deferring consumption. However, if the
inflation rate is 4 percent, the investor would be worse off in real terms if he invests at a rate
of return of 4 percent - e.g., you would receive $103, but the cost of $100 worth of goods at
the beginning of the year would be $104 at the end of the year, which means you could
consume less real goods. Thus, for an investment to be desirable, it should have a return of
7.12 percent [(1.03 x 1.04) - 1], or an approximate return of 7 percent (3% + 4%).

13. Assume the expected long-run growth rate of the economy increased by 1 percent and
the expected rate of inflation increased by 4 percent. What would happen to the
required rates of return on government bonds and common stocks? Show graphically
how the effects of these changes would differ between these alternative investments.

Answer: Both changes cause an increase in the required return on all investments. Specifically, an
increase in the real growth rate will cause an increase in the economy’s RFR because of a
higher level of investment opportunities. In addition, the increase in the rate of inflation will
result in an increase in the nominal RFR. Because both changes affect the nominal RFR,
they will cause an equal increase in the required return on all investments of 5 percent.
 The graph should show a parallel shift upward in the capital market line of 5 percent.

NRFR*

NRFR

14. You see in The Wall Street Journal that the yield spread between Baa corporate bonds
and Aaa corporate bonds has gone from 350 basis points (3.5 percent) to 200 basis
points (2 percent). Show graphically the effect of this change in yield spread on the
SML and discuss its effect on the required rate of return for common stocks.

Answer: Such a change in the yield spread would imply a change in the market risk premium
because, although the risk levels of bonds remain relatively constant, investors have changed
the spreads they demand to accept this risk. In this case, because the yield spread (risk

NRFR

premium) declined, it implies a decline in the slope of the SML as shown in the following
graph.

15. Give an example of a liquid investment and an illiquid investment. Discuss why you
consider each of them to be liquid or illiquid.

Answer: The ability to buy or sell an investment quickly without a substantial price concession is
known as liquidity. An example of a liquid investment asset would be a United States
Government Treasury Bill. A Treasury Bill can be bought or sold in minutes at a price
almost identical to the quoted price. In contrast, an example of an illiquid asset would be a
specialized machine or a bundle of real estate in a remote area. In both cases, it might take a
considerable period of time to find a potential seller or buyer and the actual selling price
could vary substantially from expectations.
 CHAPTER 1

Answers to Problems

3. $4,000 used to purchase 80 shares = $50 per share

Therefore: HPY (Total) = HPY (Price Increase) + HPY (Div)

.280 = .180 + HPY (Div)
.10 = HPY (Dividends)

For Problem #1: HPR = 1.191

For Problem #2: HPR = .985

For Problem #3: HPR = 1.280

Stock T is more desirable because the arithmetic mean annual rate of return is higher.

By this measure, B would be preferable

 By this measure, T would be preferable.

5(d). Geometric Mean (GM) = 1/n – 1

where  = Product of the HRs

GMT = [(1.19) (1.08) (.88) (.97) (1.15)]1/5 -1

= [1.26160] 1/5 –1 = 1.04757 –1 = .04757

GMB = [(1.08) (1.03) (.91) (1.02) (1.04)]1/5 -1

= [1.07383] 1/5 –1 = 1.01435 – 1 = .01435

Stock T has more variability than Stock B. The greater the variability of returns, the greater
the difference between the arithmetic and geometric mean returns.

6. E(RMBC) = (.30) (-.10) + (.10) (0.00) + (.30) (.10) + (.30) (.25)

= (-.03) + .000 + .03 + .075 = .075

7. E(RACC) = (.05) (-.60) + (.20) (-.30) + (.10) (-.10) + (.30) (.20) + (.20) (.40) + (.15) (.80)
= (-.03) + (-.06) + (-.01) + .06 + .08 + .12 = .16

8. The Anita Computer Company presents greater risk as an investment because the range of
possible returns is much wider.
10. NRFR = (1 + .03) (1 + .04) – 1 = 1.0712 – 1 = .0712
(An approximation would be growth rate plus inflation rate or .03 + .04 = .07.)

11. Return on common stock = (1 + .0712) (1 + .05) – 1

= 1.1248 – 1 = .1248 or 12.48%
(An approximation would be .03 + .04 + .05 = .12 or 12%.)

As an investor becomes more risk-averse, the investor will require a larger risk premium to
own common stock. As risk premium increases, so too will the required rate of return. In
order to achieve a higher rate of return, stock prices should decline.

12. Nominal rate on T-bills (or risk-free rate) = (1 + .03) (1 + .05) – 1

= 1.0815 – 1 = .0815 or 8.15%
(An approximation would be .03 + .05 = .08.)

The required rate of return on common stock is equal to the risk-free rate plus a risk
premium. Therefore, the approximate risk premium for common stocks implied by these
data is: .14 - .0815 = .0585 or 5.85%.

(An approximation would be .14 - .08 = .06.)

 APPENDIX 1

Answers to Problems

1(a). Expected Return = (Probability of Return) (Possible Return)

1(b). Standard deviation can be used as a good measure of relative risk between two investments
that have the same expected rate of return.

1(c). The coefficient of variation must be used to measure the relative variability of two
investments if there are major differences in the expected rates of return.

2(a). E(RKCC) = (.15)(-.60) + (.10)(-.30) + (.05)(-.10) + (.40)(.20) + (.20)(.40) + (.10)(.80)

= (-.09) + (-.03) + (-.005) + .08 + .08 + .08 = .115

2 = (.15)(-.60 -.115)2 + (.10)(-.30 -.115)2

+ (.05)(-.10 -.115)2 + (.40)(.20 -.115)2
+ (.20)(.40 -.115)2 + (.10)(.80 -.115)2

= (.15)(-.715)2 + (.10)(-.415)2 + (.05)(-.215)2

+ (.40)(.085)2 + (.20)(.285)2 + (.10)(.685)2

= (.15)(.5112) + (.10)(.1722) + (.05)(.0462)

+ (.40)(.0072) + (.20)(.0812) + (.10)(.4692)

= .07668 + .01722 + .00231 + .00288 + .01624 + .04692

= .16225
2(b). Based on [E(Ri)] alone, Kayleigh Computer Company’s stock is preferable because of the
higher return available.

2(c). Based on standard deviation alone, the Gray Disc Company’s stock is preferable because of
the likelihood of obtaining the expected return.

Based on CV, Kayleigh Computer Company’s stock return has approximately twice the
relative dispersion of Gray Disc Company’s stock return.

3(b). The average return of U.S. Government T-Bills is lower than the average return of United
Kingdom Common Stocks because U.S. Government T-Bills are riskless, therefore their risk
premium would equal 0. The U.K. Common Stocks are subject to the following types of
risk: business risk, financial risk, liquidity risk, exchange rate risk, (and to a limited extent)
country risk.

3(c). GM = 1/n – 1
US = (1.063) (1.081) (1.076) (1.090) (1.085) = 1.462

GMUS = (1.462)1/5 – 1 = 1.079 – 1 = .079

UK = (1.150) (1.043) (1.374) (1.192) (1.106) = 2.1727

GMUK = (2.1727)1/5 – 1 = 1.1679 – 1 = .1679

In the case of the U.S. Government T-Bills, the arithmetic and geometric means are
approximately equal (.079), therefore the standard deviations (using E(Ri) = .079) would be
equal. The geometric mean (.1679) of the U.K. Common Stocks is lower than the arithmetic
mean (.173), and therefore the standard deviations will also differ.