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CHAPTER 2 THE BUSINESS ENVIRONMENT ANSWERS TO END OF CHAPTER QUESTIONS: 1. Financial markets are where trading in financial assets take place. Financial markets are generally classified into primary and secondary markets. Primary markets are where new securities or primary claims are issued resulting in cash inflow to the issuer. Secondary markets are markets where already existing financial claims such as stocks and bonds are bought and sold. 2. In a direct transfer of funds from savers to borrowers, borrowers issue primary claims to savers and savers provide needed funds to borrowers. In the case of a corporation, the primary claims include bonds, preferred stock, and common stock. Usually direct transfers are undertaken with the help of an investment banker who underwrites the issue, i.e., the investment banker buys the primary claim issue from the corporation and resells it to the public at a slightly higher price. 3. Money markets deal in short-term securities having maturities of approximately one year or less, whereas capital markets deal in longer-term securities having maturities greater than one year. Examples of money market instruments include Treasury bills, commercial paper and certificates of deposit. Examples of capital market instruments include Treasury bonds, preferred stock, and common stock. 4. Financial intermediaries include the following. • Commercial banks - Sources of funds are demand and time deposits. Uses of these funds are loans to individuals, businesses (short-term credit and term loans), and governments. • Thrift institutions – Savings institutions that take deposits and invest mainly in consumer loans and mortgage loans. • Investment companies – Mutual funds that pool savings of many individuals and invest in portfolios of securities. They invest in a wide variety of primary claims including bonds and stocks. • Pension funds - These intermediaries pool the contributions of employees (and/or employers) and invest them in wide variety of primary claims to meet retirement obligations. Investments may include bonds, stocks, and real estate. • Insurance companies - Sources of funds are premiums (payments) from individuals and organizations (policyholders). In exchange for these premiums, the insurance companies agree to make certain future contractual payments, such as death and disability benefits and compensation for financial losses arising from fire, theft, accident, or illness. The premiums are used to build reserves, which are invested in various types of financial and real assets.

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• Finance companies - These are non-deposit taking intermediaries that obtain funds by issuing their own securities and through loans from commercial banks. The funds then are loaned to individuals and businesses. 5. In primary financial markets, new securities from an issuing firm are bought and sold for the first time. Hence, firms actually raise the capital they need in the primary financial markets. In secondary markets, existing securities are offered for resale. The issuing firm does not receive any new funds when securities trade in a secondary market, such as the New York Stock Exchange. Secondary markets provide an important service of making securities liquid, thus the existence of secondary markets lowers the cost of raising funds in the primary markets. 6. The New York Stock Exchange is a physical location where buyers and sellers of securities meet to exchange assets. The New York Stock Exchange works through a specialist system and complex computer linkages that match buyers and sellers and maintain an orderly market. In contrast, the over-the-counter markets are not represented by any physical place of doing business. Rather, broker/dealer firms around the country are linked together in a computer network that lists the securities that are for sale (or desired for purchase), by whom, and at what price. When an investor wishes to buy or sell stocks overthe-counter, that investor’s broker will check the computer network to see what other broker has the desired security for sale, in what quantity, and at what price. When an agreeable match occurs, the security is bought for the investor. 7. Securities markets are considered to be efficient if prices instantaneously reflect in an unbiased manner all relevant information about that security. If markets are not efficient, or slow to react to new information, a person could easily attain abnormal profits by trading on the security after the release of the information. The three levels of market efficiency are the weak-form, semistrong-form, and strongform efficiency. Markets are considered to be weak form efficient if no investor can consistently earn excess (or abnormal) returns based on an investment strategy using historical stock market information such as past prices, returns, or volume of trading. Markets are considered to be semistrong efficient if no investor can consistently earn excess returns based on an investment strategy using any publicly available information. Publicly available information would include things such as announcements of earnings, dividends, sales, annual report releases, mergers, etc. Strong-form efficiency states that security prices would reflect all information, both public and private. Thus, in a strong-firm efficient capital market, no individual or group should be able to consistently earn abnormal profits, including insiders possessing private information about the economic profits of the firm. 8. Electronic communications networks or ECNs represent the latest development in how stocks are traded. Unlike the auction based organized stock exchanges or the OTC dealer markets, ECNs are designed to bring buyers and sellers together directly. Buyers and sellers enter the amount and the prices at which they are willing to trade and the ECN automatically matches the buyers and sellers. The potential savings for investors can be very significant because there are no dealer spreads and no broker commissions to be incurred. The ECN also provides complete anonymity to the participants. Some of the better known ECNs are ArcaEx, INSTINET, Bloomberg Tradebook, and Brut ECN.

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9. A stock market index is an indicator that captures how a broad class of stocks are performing. Popular stock market indexes include the Dow Jones Industrial Average and the S&P 500 index. 10. Financial intermediaries provide several benefits including diversification, expertise, liquidity, convenience, and risk management.  Diversification. Because financial intermediaries pool the funds from many investors they are able to invest in a well-diversified combination of securities which would otherwise be difficult to do for an individual with a limited amount of funds to invest. By diversifying the investor is able to reduce some of the risk.  Expertise. Since most financial intermediaries are experts in their lines of business, you get the benefit of their professional expertise.  Liquidity. Investing in the secondary claims of financial intermediaries is generally more liquid than investing in the primary claims of ultimate borrowers. For example, banks stand ready to redeem your account at a moment's notice, but the same cannot be said of an investment in the common stock of smaller firms.  Convenience. Financial intermediaries such as banks, thrifts, and even mutual funds provide the convenience of check writing privileges, record keeping services, and the simplicity of "one-stop shopping” for other personal financial services.  Risk management. Financial intermediaries also provide an important risk management function. For example, a life insurance policy on the breadwinner of the family can eliminate some of the extreme consequences associated with loss of life on household income. Likewise by investing in an insured bank deposit an investor can virtually eliminate any default risk that he or she would otherwise experience if the money were invested directly in a corporation. SOLUTIONS TO PROBLEMS: 1. a. b. c. d. e. 2.

3.44% 10.79% 5.36% 7.96% 22.43%

Realized percentage holding period return: = [(4400 - 4000 + 4(40))/4000] x 100% = 14% Note: This problem ignores transaction costs. Also, since the stock has been sold, next year’s expected price performance is irrelevant.

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Percentage holding period return = [(9,500 - 10,000 + 2(600))/10,000] x100% = 7% Note: This solution ignores interest the investor may have received from reinvesting the first $600 interest payment.


Percentage holding period return: = [($1,000 - $975 + $60)/$975] x 100% = 8.72%


a. Expected percentage holding period return = [(65 - 60 + 4)/60] x 100% = 15.0% b. Realized percentage holding period return = [(75 - 60 + 4)/60] x 100% = 31.67% c. Realized percentage holding period return = [(58 - 60 + 4)/60] x 100% = 3.33% d. Realized percentage holding period return = [(50 - 60 + 4)/60] x 100% = -10.0%


Percentage holding period return (based on equity investment only) = [($190,000 - $110,000)/$33,000] x 100% = 242.42% over the 6 month holding period. Note: This solution assumes the interest free loan was taken in which case your investment is the equity in the land.


Expected percentage holding period return = [($45 - $35)/$35] x 100% = 28.57% The stock appears to be a good investment because the expected return of 28.57% exceeds the required rate of return of 18%.


Holding period return: = [$45,000 - $15,000 - 10($500) - $400] / $15,000 = 164%


a. Best Buy dividend yield: 0%, Best Buy does not pay a dividend on its common stock DuPont dividend yield: 3.4% General Electric dividend yield: 2.7% b. General Electric price-earnings ratio: 19x DuPont price-earnings ratio: 22x c. Best Buy’s previous day closing price = $32.34 - $1.55 = $30.79

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d. $28.49 e. Difference between the lowest and highest price paid for General Electric stock in the past 52 weeks: = $34.15 – 21.30 = $12.85 10.

a. ConocoPhillips = $59.00 Amerada Hess = $71.25 b. $959.72 c. Since the maturities are similar, the difference in the yield to maturities is most likely due to differences in default risk between the two bonds.


From the Yahoo! Research page you can get the following historical information for Wal-Mart: Stock price at end of 2003 (December 31, 2003): $53.05 Stock price at end of 2004 (December 31, 2004): $52.82 Dividends paid in 2004 (date and amount per share) March 17, 2004: $0.13 May 19, 2004: $0.13 August 18, 2004: $0.13 December 15, 2004: $0.13 Total dividends paid in 2004 (per share): $0.52 Holding period return: ($52.82-$53.05+$0.52)/$53.05 = 0.55%


No recommended solution.

Solution manual fundamentals of contemporary financial management 2nd edition moyer