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Chapter 02 - R 1 R 2 R 3 R 4 R 5.R 6 CHAPTER 2 REVIEW...

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Unformatted text preview: R. 1. R. 2. R. 3. R. 4. R. 5. .R. 6. CHAPTER 2 REVIEW QUESTIONS Market efficiency has vast and important implications for the financial manager. Most importantly, prices in efficient markets are accurate and reflect actual values such that the benefits of investment equal their cost. In other words, in efficient markets, investments are not under or over priced. Financial managers are directed to invest in markets that are not efficient or inefficient such that projects can be found whose benefits are greater than costs. Real assets directly produce or help produce scarce resources, while financial assets are claims on the cash flows of real assets. Common types of tangible real assets include include land, buildings, and equipment, and intangible real assets include trademarks, patents, and human productivity. Common types of financial assets include stocks and bonds issued by corporations. Equity securities, broadly classified as common stock, are claims on the residual cash flows of the corporation. These claims represent a pro—rata right to the firm’s residual cash flows. In contrast, debt securities pay fixed claims usually offered at specific intervals in time, say every six months. Debt claims must be paid before any residual cash flow flows through to the equityholders. Auction markets are markets where trades are conducted at centralized locations. The auctioneer serves as a "matchmaker" for buyers and sellers willing to transact at the same price. The New York Stock Exchange is an example of an auction market. In dealer markets, dealers buy and sell securities and hold them in inventory, announcing to willing buyers and sellers that securities will be offered at a certain price. The buyer and seller purchase the securities from the dealer who earns a commission equal to the difference between the bid price and the asked price. The Over—The—Counter market is an example of a dealer market. Agency theory investigates how a group of persons, called the principals, contract with another group of persons, called the agents. In a corporate setting, shareholders are the principals who form contracts with the agents, or the managers, to make decisions on behalf of the shareholders. There are two types of agency costs; (1) the costs of trying to get the agents to do what the principals want, and (2) the lost opportunities caused by conflicts which are too expensive to resolve. Shareholders might choose to incur costs of monitoring managers to insure that, for example, managers do not waste home office supplies foolishly. Shareholders may in certain situations, choose not to incur monitoring costs and instead to bear these expenses as lost opportunities. R. 7. The primary tool used by shareholders to minimize agency costs is the compensation plan. The compensation plan is the procedure by which the principal and agent have contracted with regard to the basis upon which the agent will be paid. Typical compensation plans are salary and bonus ' agreements. The best compensation plan is one that links together the desires of the managers with the desires of the shareholders, such as a salary combined with a bonus based upon the performance of the firm’s stock. CHAPTER 2 PROBLEMS 1. b. most liquid 0. moderately liquid a. least liquid 2.a.F b.R c.F d.R e.R 3. a. Bigstuff Corporation’s shareholders gain and the citizens of the county lose. b. Dangerous Products, Inc. shareholders lose while the citizens of West Rochester and the lawyers gain. c. Shareholders of Creditor Corporation lose to shareholders of Debtor Corp. d. Citizens of United States lose while citizens or" Herbanna gain. 4. a. Federal income tax on $125,000 (married filing jointly): $24,404 Amount Rate Tax $15,100 10% $1,510 $46,200 15% $6,930 $62,400 25% $15,600 $1,300 28% $364 $125,000 $24,404 b. $24,404 / $125,000 = > 19.5% c. $280. The extra $1,000 will be taxed at 28%. d. Federal income tax on $10,000 (married filing jointly): $1,000 Amount Rate Tax $10,000 10% $1,000 $10,000 $1,000 Average and marginal tax rates: 10% 5. a. Federal income tax on $1,100,000 (corporate): $374,000 Amount Rate Tax $50,000 15% $7,500 $25,000 25% $6,250 $25,000 34% $8,500 $235,000 39% $91,650 $765,000 34% $260,100 $1,100,000 $374,000 Note: there is a minor error in the example in Workshop 2.1 b. $374,000/ $1,100,000 = > 34.0% 0. $340. The extra $1,000 will be taxed at 34%. d. Federal income tax on $60,000 (corporate): $10,000 Amount Rate Tax $50,000 15% $7,500 $10,000 25% $2,500 $60,000 $10,000 Average rate, 16.7%, and the marginal tax rate 25% 6. a. (200 shares x $20 per share) X (102.5%) = $4,100 b. (200 shares x $20 per share) x (97.5%) = $3,900 c. $200 loss d. Ebay and Paypal fees would be analogous. Whether you could buy and sell at the same price might depend on how "anxious" each party was and other factors. To buy at a low price, a buyer must be willing to wait for an anxious seller and to take the chance that the price may rise while waiting for an anxious seller. To sell at a high price , a seller must be willing to wait for an anxious buyer and to take the change that the price will fall while waiting. 7. a. 100 shares x $10.75 per share = $1,075 b. 100 shares x $10.25 per share = $1,025 c. $50 loss (1. Ebay and Paypal fees would be need to be included. The prices used seem to imply that the investor was an anxious buyer and than was an anxious seller. That is exactly the bahavior that most investors exhibit when they place "market" orders and is how market makers get compensated for their role of providing liquidity. 8. a. 3 additional hours maximize profit. b. Offer Nick the salary bonuses in column 3 for producing the additional daily profits shown in column 2 or simply offer Nick the optimum bonus level of $45 for producing $230 additional profit each day. c. Nick would quit. d. No. This problem attempts to focus management of the principal~agent 1O relationship on the compensation scheme. Some management approaches advocate the use of seminars, workshops and retreats in an attempt to get Nick to abandon his self—interest. A compensation scheme based approach attempts to align the self—interests of the parties involved. 9. Probably not. Note that the overall cost savings would be small. However, it is possible that the firm has been able to retain workers at a lower wage because the firm is able to offer non—cash compensation such as free parking, mailing, phone calls and office supplies. There are several important points. First, there is non—cash compensation in addition to cash compensation. Second, sometimes the optimal principal—agent relationship allows certain conflicts to remain unresolved since it is not cost efficient to resolve all conflicts. Finally, it may be noted that there is a tax advantage to certain types of non—cash compensation since it is generally untaxed. 10. a. Jack’s analysis may be true —— but it does not necessarily imply any level of market inefficiency. It may be possibile to be able to predict some interest rate movements (inflation is somewhat predictable) —-— but in order to refute market efficiency, the theory must be capable of earning superior risk adjusted returns. So an interest rate prediction theory would have to predict interest rates better than they are predicted in the marketplace as reflected and contained in current rates. b. The firms behind investment newsletters can send out millions of junk emails or bulk mailings with different stock picks knowing that some recipients will receive a string of good picks and will be fooled into thinking it was skill. Unless consistent results are demonstrated, the cases of success will be nothing more than statistical flukes. The human mind is surprisingly poor at differentiating between causation and randomness when using casual analysis. c. As in the previous question regarding stock picks, some argue that fund families generate many, many funds with various risks, eventually closing the "losers" and promoting the "winners" as skill rather than luck. But it could be worse, some people allege that drug companies test high numbers of worthless new drugs in the hopes that some will generate positive test results through being a statistical outlier and not revealing how many drugs were initially tested so that consumers could discern the probabilities that the results were statistical flukes rather than indications of the drug’s effectiveness. d. This would indicate strong level inefficiency of the market for collectibles. In other words, it would argue against the efficiency of the classified ads in that newspaper for collectibles. 11 CHAPTER 2 DISCUSSION QUESTIONS 1. The key word is ”consistently". With tens of millions of active investors and with tens of thousands of professional investment managers it should be expected that some investors will "beat the market" many time periods in a row. Market efficiency merely requires that performance exceeding the market is random rather than consistent. It is useful to note that several of the larger investment companies with ”families" of mutual funds contain approaching 100 different funds. There are thousands and thousands of mutual funds. If each mutual fund were assumed to have a 50% (independent) chance of ”beating" its market in each year, then out of a group of 4,096 mutual funds the expected number of funds "beating the market" for the last ten consecutive years would be 4! 2. First, there is virtually no net effect of burning a $100 bill on human wealth since human wealth is potential consumption and a $100 bill is a claim on consumption rather than potential consumption itself. The near trivial exception to this point is that the paper, ink and labor involved with producing the $100 bill are lost since currency is useful as a medium of exchange. Second, there is a $100 wealth transfer from the owner of the $100 bill (the instructor) to virtually everybody else in society since money becomes more valuable as its supply diminishes. To be precise, the recipients of the wealth transfer are all people who hold claims denominated in dollars in proportion to the size of their claims. Finally, we can extend the discussion into m0netary policy and inflation by noting that when government increases or decreases the money supply there is an immediate transfer of wealth but (perhaps) no immediate net change in total wealth. However, some people argue that the government can manipulate aggregate economic activity and therefore aggregate wealth by manipulating the money supply. 3. No, technically speaking, a corporation is a set of contracts. To be more precise it is usually useful to identify the specific people involved such as shareholders, creditors, workers and managers. 4. Silver and gold are generally considered real assets since they have value as jewelry and for industrial purposes. The fact that they are used as a medium of exchange does not make them financial assets, per se. However, some people may argue that if silver or gold take on an illusory value as a medium of exchange that departs from its industrial or cosmetic value, then it becomes a financial asset. 5. The point of this question is that there is little or no difference between a communist society and a capitalist society if the income tax rate of the capitalist society reaches 100%. Note that a communist society is where all assets are 12 owned by the society in general through the government. Further note that the value of any asset is the future consumption that it provides. Broadly defined, we could think of income as including virtually all benefits of consumption and therefore there would be no difference. The other point of the question is to investigate the idea that income taxation is a partial form of communism and that if we believe that communism is "wrong" then isn’t it logical to conclude that any income taxation is wrong? Some of the discussion can be helped using the material from Chapter 3. Note from that chapter that there are two approaches: a contractual rights approach and a societal good approach. For those students who advocate public policy on the basis of societal good or fairness, it is often useful to ask if it would be appropriate to charge tuition on the basis of a student’s grade point average since the students who learn more (receive more knowledge) should pay more! Further discussion questions on this topic inlcude: Upon what basis would students object if the government raised taxes on their income to 100% because the rest of society thought that it was fair? Is it wrong to steal money from a store but OK to shoplift a small item? Is it OK to cheat just a little on taxes but no OK to evade large amounts of taxes? . Consumption requires both natural resources and human effort or technology. Thus both types of resources are necessary. For example, a car, a sandwich, a house, a shirt, etc. require raw materials and a combination of intellect and labor. However, the tremendous wealth of one nation as contrasted with another nation, or of one time period as contrasted with another is almost always a difference in human effort and technology rather than natural resources. Were cavemen poor because there wasn’t enough oil or ore under the ground or were they poor because they lacked the technology to utilitze the resources? As discussed in the next question, virtually all of our wealth today can be attributed to the cumulated wisdom (technology) of people that preceded us. . Note that it is virtually impossible to transport a significant amount of drinking water without the help of a material, a device, a tool or an idea created by someone else. Perhaps a leaf, a hollow fruit, a hollow vegetable or a spongue could carry a little water a short distance. But the exercise should cause us to think about the primary source of wealth (the human mind) and the extent to which we live off of the intellect of other people. 13 ...
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