Week 1 solutions - the answer of week 1 PDF

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Week 1: Solutions to homework problems BKM chapter 1 9. Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni’s owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction? a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay back the loan over three years. Answer: The bank loan is a financial liability for Lanni. Lanni’s $50,000 IOU is the bank’s financial asset. The cash Lanni receives is a financial asset. The new financial asset created is Lanni’s promissory note held by the bank. b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software. Answer: The cash paid by Lanni (both the loan and its own cash) is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset, the completed software. No financial assets are created or destroyed. Cash is simply transferred from one firm to another. c. Lanni sells the software product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the form of 2,000 shares of Microsoft stock. Answer: Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni receives a financial asset, 2,000 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, this would constitute the creation of a new financial asset. d. Lanni sells the shares of stock for $70 per share and uses part of the proceeds to pay off the bank loan. Answer: In selling 2,000 shares of stock for $140,000, Lanni is exchanging one financial asset for another. In paying off the IOU with $50,000, Lanni is exchanging financial assets. The loan is "destroyed" in the transaction, since it is retired when paid.

FINC3017, INVESTMENTS AND PORTFOLIO MANAGEMENT

10. Reconsider Lanni Products from Problem 9. a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of real assets to total assets? Answer:

Assets Cash Computers Total

$70,000 30,000 $100,000

Ratio of real to total assets =

Liabilities & Shareholders’ Equity Bank loan $50,000 Shareholders’ equity 50,000 Total

$100,000

$30,000 = 0.3 $100,000

b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software product. What is the ratio of real assets to total assets? Answer:

Assets Software product* Computers Total

$70,000 30,000 $100,000

Liabilities & Shareholders’ Equity Bank loan $50,000 Shareholders’ equity Total

*Value at cost

Ratio of real to total assets =

$100,000 = 1.0 $100,000

FINC3017, INVESTMENTS AND PORTFOLIO MANAGEMENT

50,000 $100,000

c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft. What is the ratio of real assets to total assets? Answer:

Assets Microsoft shares (@$70/share) $140,000 Computers 30,000

Liabilities & Shareholders’ equity Bank loan $50,000 Shareholders’ equity 120,000

Total

Total

Ratio of real to total assets =

$170,000

$170,000

$30,000 = 0.2 $170,000

Conclusion: When the firm starts up and raises working capital, it will be characterised by a low ratio of real to total assets. When it is in full production, it will have a high ratio of real assets. When the project "shuts down" and the firm sells it, the percentage of real assets to total assets goes down again because the product is again exchanged into financial assets. BKM chapter 2 17. Turn back to Figure 2.3 and look at the Treasury bond maturing in February 2043. a. How much would you have to pay to purchase one of these bonds? Answer: You would have to pay the asked price of: 105.48 = 105.48% of par = $1,054.84 b. What is its coupon rate? Answer: The coupon rate is 3.125%, implying coupon payments of $31.25 annually or, more precisely, $15.625 (= 31.25/2) semiannually. c. What is the current yield (i.e., coupon income as a fraction of bond price) of the bond? Answer: Given the asked price and coupon rate, we can calculate current yield with the formula: Annual coupon income = 3.125/105.4844 = 0.0296 = 2.96% Current yield = Price

FINC3017, INVESTMENTS AND PORTFOLIO MANAGEMENT

18. Turn to Figure 2.8 and look at the listing for General Dynamics. a. What was the firm’s closing price yesterday? Answer: The closing price today is $194.55, which is $0.37 above yesterday’s price. Therefore, yesterday’s closing price was: $194.55 － $0.37 = $194.18. b. How many shares could you buy for $5,000? Answer: You would buy 25 shares: $5,000/$194.55 = 25.70. c. What would be your annual dividend income from those shares? Answer: Your annual dividend income on 25 shares would be 25 × $3.36 = $84.00. d. What must be General Dynamics’ earnings per share? Answer: Earnings per share can be derived from the price-earnings (PE) ratio: Given Price/Earnings = 20.03 and Price = $194.55, we know that Earnings per Share = $194.55/20.03 = $9.71. 30. What would you expect to happen to the spread between yields on commercial paper and Treasury bills if the economy were to enter a steep recession? Answer: The spread will widen. Deterioration of the economy increases credit risk, that is, the likelihood of default. Investors will demand a greater premium on debt securities subject to default risk.

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