SOLUTIONS MANUAL
CHAPTER 1
THE INVESTMENT SETTING
Answers to Text Discussion Questions
1. How is an investment defined?
1-1. An investment is the commitment of current funds in anticipation of receiving a
larger flow of funds in the future.
2. What are the differences between financial and real assets?
1-2. A financial asset represents a financial claim on an asset that is usually documented
by some form of legal representation such as a stock or bond. A real asset is an
actual tangible item such as real estate, gold, antiques, jewels, etc.
3. List some key areas relating to investment objectives.
1-3. Key areas relating to investment objectives include risk and safety of principal,
current income versus capital appreciation, liquidity considerations, short-term
versus long-term orientation in measurement, tax factors, ease of management, and
retirement and estate planning considerations.
4. Explain the concepts of direct equity and indirect equity.
1-4. Direct equity represents actual ownership of shares in a firm or the instruments that
can be used to purchase the shares (such as warrants or options). Indirect equity is
ownership of shares of an investment company that in turn owns an equity position
in other firms.
,5. How are equity and creditor claims different?
1-5. Equity claims represent ownership in something whereas creditor claims are
represented by a debt instrument.
6. Do those wishing to assume low risks tend to invest long term or short term?
Why?
1-6. Risk averters tend to invest short term because liquidity tends to be greater and
changes in prices of assets tend to be less over the short term.
,7. How is liquidity measured?
1-7. Liquidity is measured by the ability to convert an asset into cash within a relatively
short period of time with a minimum capital loss from the transaction. Liquidity can
also be measured indirectly by the transactions costs or commissions involved in
the transfer of ownership.
8. Explain why conservative investors who tend to buy short-term assets differ
from short-term traders.
1-8. Conservative investors tend to buy short term and hold to maturity, and do no
necessarily seek critical timing decisions. Short-term traders may buy long or short
term, but do not expect to hold the assets indefinitely, so timing to obtain the lower
purchase price and highest selling price is critical.
9. How does the Tax Relief Act of 2003 affect the relative attractiveness of long-term
capital gains versus dividend income? (A general statement will suffice.)
1-9. There is no longer a strong preference for long-term capital gains over dividends.
Both long-term capital gains and dividends are taxed at a maximum rate of 15
percent. This tax law was still in effect in 2011 and 2012 but students might want to
check for revisions to the law that would affect this answer.
10. Why is there a minimum amount of time that must be committed to any investment
program?
1-10. Even when someone else manages your investments, you must monitor the
managers' activities and choose the best managers.
11. In a highly inflationary environment, would an investor tend to favor real or
financial assets? Why?
, 1-11. Real assets, because they have a replacement value reflecting increasing prices. In a
more moderate inflationary environment, stocks or bonds may be preferred.
12. What two primary components are used to measure the rate of return achieved from an
investment?
1-12. The two primary components of return are capital gains (or increase in value) and
current income (for a stock, this would be represented by dividends).
CHAPTER 1
THE INVESTMENT SETTING
Answers to Text Discussion Questions
1. How is an investment defined?
1-1. An investment is the commitment of current funds in anticipation of receiving a
larger flow of funds in the future.
2. What are the differences between financial and real assets?
1-2. A financial asset represents a financial claim on an asset that is usually documented
by some form of legal representation such as a stock or bond. A real asset is an
actual tangible item such as real estate, gold, antiques, jewels, etc.
3. List some key areas relating to investment objectives.
1-3. Key areas relating to investment objectives include risk and safety of principal,
current income versus capital appreciation, liquidity considerations, short-term
versus long-term orientation in measurement, tax factors, ease of management, and
retirement and estate planning considerations.
4. Explain the concepts of direct equity and indirect equity.
1-4. Direct equity represents actual ownership of shares in a firm or the instruments that
can be used to purchase the shares (such as warrants or options). Indirect equity is
ownership of shares of an investment company that in turn owns an equity position
in other firms.
,5. How are equity and creditor claims different?
1-5. Equity claims represent ownership in something whereas creditor claims are
represented by a debt instrument.
6. Do those wishing to assume low risks tend to invest long term or short term?
Why?
1-6. Risk averters tend to invest short term because liquidity tends to be greater and
changes in prices of assets tend to be less over the short term.
,7. How is liquidity measured?
1-7. Liquidity is measured by the ability to convert an asset into cash within a relatively
short period of time with a minimum capital loss from the transaction. Liquidity can
also be measured indirectly by the transactions costs or commissions involved in
the transfer of ownership.
8. Explain why conservative investors who tend to buy short-term assets differ
from short-term traders.
1-8. Conservative investors tend to buy short term and hold to maturity, and do no
necessarily seek critical timing decisions. Short-term traders may buy long or short
term, but do not expect to hold the assets indefinitely, so timing to obtain the lower
purchase price and highest selling price is critical.
9. How does the Tax Relief Act of 2003 affect the relative attractiveness of long-term
capital gains versus dividend income? (A general statement will suffice.)
1-9. There is no longer a strong preference for long-term capital gains over dividends.
Both long-term capital gains and dividends are taxed at a maximum rate of 15
percent. This tax law was still in effect in 2011 and 2012 but students might want to
check for revisions to the law that would affect this answer.
10. Why is there a minimum amount of time that must be committed to any investment
program?
1-10. Even when someone else manages your investments, you must monitor the
managers' activities and choose the best managers.
11. In a highly inflationary environment, would an investor tend to favor real or
financial assets? Why?
, 1-11. Real assets, because they have a replacement value reflecting increasing prices. In a
more moderate inflationary environment, stocks or bonds may be preferred.
12. What two primary components are used to measure the rate of return achieved from an
investment?
1-12. The two primary components of return are capital gains (or increase in value) and
current income (for a stock, this would be represented by dividends).
