17.E: Financial Markets (Exercises)

Key Concepts

17.1 How Businesses Raise Financial Capital

Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms.

A bond is a financial contract through which a borrower agrees to repay the amount that it borrowed. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury.

Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company’s first stock sale to the public the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. One receives the rate of return on stock in two forms: dividends and capital gains.

A private company is usually owned by the people who run it on a day-to-day basis, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.

17.2 How Households Supply Financial Capital

We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure.

A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.

Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.

We can also regard housing and other tangible assets as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.

17.3 How to Accumulate Personal Wealth

It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price will rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life.

Questions

1. Answer these three questions about early-stage corporate finance:

1. Why do very small companies tend to raise money from private investors instead of through an IPO?
2. Why do small, young companies often prefer an IPO to borrowing from a bank or issuing bonds?
3. Who has better information about whether a small firm is likely to earn profits, a venture capitalist or a potential bondholder, and why?

2. From a firm’s point of view, how is a bond similar to a bank loan? How are they different?

3. Calculate the equity each of these people has in his or her home:

1. Fred just bought a house for $200,000 by putting 10% as a down payment and borrowing the rest from the bank.
2. Freda bought a house for $150,000 in cash, but if she were to sell it now, it would sell for $250,000.
3. Frank bought a house for $100,000. He put 20% down and borrowed the rest from the bank. However, the value of the house has now increased to $160,000 and he has paid off $20,000 of the bank loan.

4. Which has a higher average return over time: stocks, bonds, or a savings account? Explain your answer.

5. Investors sometimes fear that a high-risk investment is especially likely to have low returns. Is this fear true? Does a high risk mean the return must be low?

6. What is the total amount of interest from a $5,000 loan after three years with a simple interest rate of 6%?

7. If you receive $500 in simple interest on a loan that you made for $10,000 for five years, what was the interest rate you charged?

8. You open a 5-year CD for $1,000 that pays 2% interest, compounded annually. What is the value of that CD at the end of the five years?

9. What are the most common ways for start-up firms to raise financial capital?

10. Why can firms not just use their own profits for financial capital, with no need for outside investors?

11. Why are banks more willing to lend to well-established firms?

12. What is a bond?

13. What does a share of stock represent?

14. When do firms receive money from a stock sale in their firm and when do they not receive money?

15. What is a dividend?

16. What is a capital gain?

17. What is the difference between a private company and a public company?

18. How do the shareholders who own a company choose the actual company managers?

19. Why are banks called “financial intermediaries”?

20. Name several different kinds of bank account. How are they different?

21. Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest?

22. Why should a financial investor care about diversification?

23. What is a mutual fund?

24. What is an index fund?

25. How is buying a house to live in a type of financial investment?

26. Why is it hard to forecast future movements in stock prices?

27. What are the two key choices U.S. citizens need to make that determines their relative wealth?

28. Is investing in housing always a very safe investment?

29. If you owned a small firm that had become somewhat established, but you needed a surge of financial capital to carry out a major expansion, would you prefer to raise the funds through borrowing or by issuing stock? Explain your choice.

30. Explain how a company can fail when the safeguards that should be in place fail.

31. What are some reasons why the investment strategy of a 30-year-old might differ from the investment strategy of a 65-year-old?

32. Explain why a financial investor in stocks cannot earn high capital gains simply by buying companies with a demonstrated record of high profits.

33. Explain what happens in an economy when the financial markets limit access to capital. How does this affect economic growth and employment?

34. You and your friend have opened an account on E-Trade and have each decided to select five similar companies in which to invest. You are diligent in monitoring your selections, tracking prices, current events, and actions the company has taken. Your friend chooses his companies randomly, pays no attention to the financial news, and spends his leisure time focused on everything besides his investments. Explain what might be the performance for each of your portfolios at the end of the year.

35. How do bank failures cause the economy to go into recession?

36. The Darkroom Windowshade Company has 100,000 shares of stock outstanding. The investors in the firm own the following numbers of shares: investor 1 has 20,000 shares; investor 2 has 18,000 shares; investor 3 has 15,000 shares; investor 4 has 10,000 shares; investor 5 has 7,000 shares; and investors 6 through 11 have 5,000 shares each. What is the minimum number of investors it would take to vote to change the company's top management? If investors 1 and 2 agree to vote together, can they be certain of always getting their way in how the company will be run?

37. Imagine that a local water company issued $10,000 ten-year bond at an interest rate of 6%. You are thinking about buying this bond one year before the end of the ten years, but interest rates are now 9%.

1. Given the change in interest rates, would you expect to pay more or less than $10,000 for the bond?
2. Calculate what you would actually be willing to pay for this bond.

38. Suppose Ford Motor Company issues a five year bond with a face value of $5,000 that pays an annual coupon payment of $150.

1. What is the interest rate Ford is paying on the borrowed funds?
2. Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease?

39. How much money do you have to put into a bank account that pays 10% interest compounded annually to have $10,000 in ten years?

40. Many retirement funds charge an administrative fee each year equal to 0.25% on managed assets. Suppose that Alexx and Spenser each invest $5,000 in the same stock this year. Alexx invests directly and earns 5% a year. Spenser uses a retirement fund and earns 4.75%. After 30 years, how much more will Alexx have than Spenser?