Solution Manual for Practical Financial

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Chapter 5

THE FINANCIAL SYSTEM, CORPORATE GOVERNANCE, AND INTEREST

FOCUS
This chapter begins with an overview of the flow of funds around the economy concentrating on
the role of financial markets in channeling consumers' savings to companies for investment in
productive resources. The operation of the stock market is studied in some detail.
The second part of the chapter deals with ethics in corporate governance and its effect on the
financial and accounting world. We discuss business ethics in the context of executive compensation
and the moral hazard created by stock based compensation systems and the temptations they can create
for executives who can influence financial reporting. From there we embark on reviews of the two
major financial crises of the first decade of the twenty-first century. We cover the excesses of the
1990s, the market decline of 2000, and the government’s attempt to legislate against a recurrence in the
Sarbanes-Oxley Act of 2002. We then briefly summarize the major provisions of SOX.
The next section is a detailed review of the financial crisis of 2008. The treatment begins with
home mortgages and the concept of borrower qualification as well as certain problems faced by lenders
if they retain mortgages on their own balance sheets. We then cover securitization and the emergence of
Collateralized Debt Obligations (CDOs) as well as the reasons for their popularity before the crisis.
That leads into the subprime mortgage market and the eventual risk condition of the CDOs that
permeated the financial community on the eve of the crisis. We then review the interest rate increases
in 2004-6 that triggered subprime mortgage defaults and the fall of CDOs that froze credit markets. We
the discuss why the crises was a governance issue regarding ethics rather than illegality, and end with a
brief treatment of the Dodd-Frank Act.
The third part of the chapter involves a detailed study of interest and its effect on financial
markets. The nature of interest is explored breaking the observed rate into its components of a pure rate,
an inflation adjustment, and compensation for bearing various risks. We end with a discussion of yield
curves and interest rate spreads as predictors of economic activity.

TEACHING OBJECTIVES
Students should gain an understanding of the basic financial flows around an industrialized
economy and how those flows are made possible by organized financial markets. They should also
acquire a working knowledge of how the stock market functions and understand how to read stock
quotations. In addition students should develop an understanding of the concepts underlying interest
including the pure rate, inflation, and various risk elements.
They should also come to appreciate the idea of corporate governance and the ethical issues
faced by executives.
In the section on the financial crisis they should develop an understanding of the reasons behind
the crisis of 2008 and a familiarity with the major events and bailouts that took place as it developed.

111
112 Chapter 5

OUTLINE

I. THE FINANCIAL SYSTEM

The economy consists of Production and Consumption sectors. Each is described briefly.
A. Cash Flows Between the Sectors
Wages paid by the production sector are income to the consumption sector while purchases
made by consumers become income to producers.
B. Savings and Investment
Savings, investment, and their relationship defined and explained.
C. Financial Markets
Financial markets facilitate the transfer of funds from savers to companies for investment in
productive resources. Capital markets, money markets, primary and secondary markets,
financial intermediaries.

II. THE STOCK MARKET AND STOCK EXCHANGES

A. Overview
Definition of the "market" and an exchange.
B. Trading - The Role of Brokers
How financial transactions are made through brokerage organizations.
C. Exchanges
The nature of an exchange as a part of the market.
D. Private, Public, and Listed Companies, and the OTC Market
The progression of a firm from private to public to listed. Description of the OTC market and
what is traded on it.
E. Stock Quotations

III. CORPORATE GOVERNANCE

A.. Executive Compensation and the Agency Problem
The moral hazard created by stock options among those in positions to influence financial
reporting.
B. The events of the 1990s.
C. The Provisions of the Sarbanes-Oxley Act
How SOX addresses many of the major problems uncovered in the areas of public accounting,
corporate governance, and Wall Street’s financial analysts.

IV. The Financial Crisis of 2008

A. Background: Home Ownership, Mortgages and Risk
Qualifying for a mortgage, qualifications as safety for lenders, especially equity. Bank’s
perspective: liquidity and interest rate risk.
B. Securitization
Selling loans to an issuer who issues Collateralized Deb Obligations (CDOs) against the cash
flows. Risk in CDOs and its flawed allocation through tranches.
C. The Sub-Prime Mortgage Market
The increased demand for CDOs and the mortgage industry’s response of loosening the
standards for qualification.
D, Subprime Techniques and Implications
Zero down loans mean no equity cushion for lenders, adjustable rate mortgages (ARMs) mean
borrowers can’t survive higher interest rates, negative amortization loans, borrower rationale for high
risk loans, political pressure to extend home ownership to lower income families.
E. The Credit Default Swap (CDS)
 The Financial System and Interest 113

Seems like insurance but it isn’t. Ties financial institutions together in a web so complex no
one knows their exposure.
F. The Scene is Set
Summary of financial and risk conditions on the eve of the crisis.
G. The Trigger – Interest Rates Rise
The Fed raises rates 2004–6 to prevent inflation triggering massive defaults on subprime loans.
H. The Effect on the CDO Market and CDO Owners
CDO default risk is recognized which leads to the inability to price CDOs which causes trading
to stop. The absence of market prices causes massive write downs on the balance sheets of financial
institutions some of which approach failure. Banks stop lending which along with psychological
pressures causes a slowing of economic activity and brings on a recession.
I. Federal Government Actions in 2008
The government takes over some failing firms, brokers mergers of others with stronger firms, and
injects cash.
J. The End of the Crisis and the Lingering Recession
Why the crisis was an ethical issue of corporate governance.
Bailouts as Moral Hazards
K. The Dodd-Frank Act
Complexity of the problem, goals of the new law, and implementation problems.

V. INTEREST
Interest is the return on a debt investment.
A. The Relationship Between Interest and the Stock Market
How the interest rate drives securities prices.
B. Interest and the Economy
How the interest rate influences economic activity.
C. Debt Markets
The supply and demand for borrowed money determines the interest rate. Relating supply and
demand curves for debt to those for commodities.
B. Base Rate
The pure rate plus an inflation adjustment.
C. Risk Premiums
Premiums for bearing default, liquidity and maturity risk.
D. Putting the Pieces Together
The interest rate is the sum of the pure rate, anticipated inflation, and several risk premiums.
D. Federal Government Securities, Risk Free and Real Rates
Characteristics of treasury securities. Real and risk free rates.
E. Yield Curves - The Term Structure of Interest Rates
Three theories of the shape of the yield curve.

QUESTIONS

1. Describe the sectors into which economists divide an industrialized economy and outline the
financial flows between them.

ANSWER: An economy can be divided into production and consumption sectors. The production
sector makes products using labor from the consumption sector which are sold to individuals in the
consumption sector. Money flows from the production sector to consumers in the form of wages paid
for labor services. Money flows from the consumption sector the production sector in the form of the
prices paid for goods and services. The government can be included as part of the production sector
selling its services for taxes.
114 Chapter 5

2. What do we mean when we say businesses spend two kinds of money? Where does each kind
come from? How is each used?

ANSWER: Funds generated by everyday operations are used to fund routine activities like buying
inventory and paying wages and expenses. Occasionally, large sums need to be spent on major projects
like acquiring new physical assets or getting businesses started. These "long term" funds are raised by
selling financial assets.

3. What is the primary purpose of financial markets?

ANSWER: The primary purpose of financial markets is to transfer savings from consumers to
companies that need those funds for investment in business projects.

4. Define the following terms: primary market, secondary market, capital market, money market.

ANSWER:
Primary market - Transactions involving the (first) sale of securities by companies to investors (savers).
Secondary market - Sales of securities between investors.
Capital market - Any market which trades securities whose duration is longer than one year. These are
generally longer term debt and equity.
Money market - A market for debt that must be repaid in one year or less.

5. What's the difference between a direct and an indirect transfer of money between investors and
firms?

ANSWER: In a direct investment, the investor buys the security of the issuing company. In an indirect
investment he or she buys the security of a financial intermediary which in turn buys the security of the
issuing firm.

6. Your friend Sally just returned from a trip to New York where she was very impressed by a visit
to the stock market. Is it correct to say that she visited the stock market? What exactly did Sally visit?
Is there more than one place in New York that she might have visited? Explain exactly what the stock
market is and how it's related to what Sally visited.

ANSWER: It's not quite correct to say that Sally visited the stock market. She actually visited a stock
exchange. The stock market consists of a network of brokers and exchanges that bring investors and the
issuers of securities together. The exchange is a physical place where some of that activity takes place.
Most importantly, the exchange provides a forum for the bidding process that characterizes the sale of
securities. Much of the paperwork involved in transferring securities from sellers to buyers is also done
at exchanges. In New York City Sally could have visited either the New York Stock Exchange or the
American Stock Exchange.

7. Describe the process that occurs when an investor places an order with a broker to buy or sell
stocks.

ANSWER: The local broker phones the order to an associated floor broker at the exchange. The floor
broker goes to the station of the appropriate designated market maker (specialist) in the stock on the
exchange floor. There he or she engages in an auction to buy or sell shares of the stock. When the
transaction is complete, notification is made back to the local broker who can call the investor with the
exact price of the trade. A paperwork confirmation follows several days later.
 The Financial System and Interest 115

8. Your friend Charlie is excited about a newly issued stock. You've looked at the company's
prospectus and feel it's a very risky venture. You told Charlie your opinion, and he said he wasn't
worried because the stock has been approved by the SEC and therefore must be OK. Write a paragraph
to help Charlie out. What is the main thrust of federal securities regulation?

ANSWER: SEC approval means only that the company appears to have complied with the SEC's
regulations about disclosure. It says nothing about the quality or investment potential of the business.
A terrible business with no chance of success, run by people with a history of shady dealing, can be
approved if the appropriate facts are revealed.
Approval doesn't even guarantee the truth of the information provided about a company,
because the commission doesn't have the resources to check out all submissions. The thrust of securities
regulation is disclosure. The laws provide stiff penalties for being caught hiding information. However,
in order to enforce the penalties injured parties have to complain after they've lost money. By that time
they're unlikely to get it back.

9. Describe insider trading. Why is it illegal?

ANSWER: Insider trading refers to making a profit on securities about which a person has "inside"
information that's not available to the general public. It's illegal because such transactions defraud
(cheat) the other party to the trades who don't have access to the inside information.

10. Explain the following terms: privately held company, publicly traded company, listed company,
OTC market, IPO, prospectus, and red herring.

ANSWER:
Privately held company - A firm that isn't registered with the SEC whose securities cannot be sold to
the general public.
Public company - A firm that is registered with the SEC whose stock can be sold to the general public.
Listed company - A public company whose stock is "listed" and traded on a recognized, organized
exchange.
OTCBB - The Over the Counter Bulletin Board, a network of dealers who trade public but unlisted
stocks.
Nasdaq – A third major exchange that competes with the NYSE and AMEX. Nasdaq is an electronic
exchange while the others are physical location exchanges.
IPO - Initial Public Offering, the first offering of a particular security by a public company.
Prospectus - a document disclosing the details of a company's organization and business and
something about its officers to prospective investors.
Red Herring - a preliminary prospectus in the review process by the SEC. So-called because of a red
stamp indicating its status.

11. Define term and maturity. Is there a difference?

ANSWER: Both mean the length of time until a bond's principal is repaid. There is essentially no
difference.

12. Corporate executives sometimes abuse their positions by overpaying themselves at the expense
of stockholders. When that happens are the executives’ gains dollar for dollar losses to stockholders or
can investors lose more or less than the amounts by which the executives profit. Explain thoroughly.

ANSWER: If the excessive compensation is in the form of salary or cash bonuses, the amounts
transferred to executives are reductions to profit which belongs to stockholders, so stockholder losses
are equal to executive gains. But if the executive gains are based on a stock price that’s been inflated
116 Chapter 5

by questionable financial reporting and then crashes when the deception is discovered, stockholder
losses are likely to total many times the gains of the unscrupulous executives. That’s because millions
of investors may have purchased overpriced shares and will lose most of their investments when the
price crashes.

13. Why does stock based compensation create a moral hazard for executives.

ANSWER: The idea behind stock based compensation is to give executives an incentive to manage
their companies efficiently and profitably, which leads to legitimately high stock prices. That’s good
for investors as well as executives and is what everyone wants.
However it’s also possible to pump up stock price by issuing deceptive financial statements
that make the company look better than it is. This also leads to increased compensation for executives,
but it also leads to big investor losses when stock price falls quickly after the deception is discovered.
Hence stock based compensation tempts executives to be unethical by giving them the opportunity to
make money for themselves at the expense of someone else, the stockholders. That’s a moral hazard.

14. Describe the primary conflict of interest that caused the public accounting industry to fail in its
duty to protect the investing public’s interests in the 1990s.

ANSWER: Public accounting firms were selling consulting services to audit clients in the 1990s. As
the decade progressed they made little money on audits but a lot on consulting. That led to a
willingness on the part of auditors to overlook violations of accounting rules in order to curry favor
with client executives in order to sell more consulting business. The conflict of interest lies in selling
auditing and consulting to the same client, because auditing requires independence which is
compromised by the motivation to sell more consulting.

15. Why did securities analysts issue biased reports in the 1990s? In what direction were the
reports biased?

ANSWER: Securities analysts issued reports that were favorably biased. That is, they said companies
were in better financial condition than they actually were. Analysts did this because they worked for
brokerage houses that also did investment banking business with the firms being analyzed. Poor
reports would mean these companies would be likely to take their investment banking business
elsewhere. Hence top managements of the brokers/investment bankers pressured analysts to issue only
favorable or neutral reports regardless of how weak the client firms were.

16. List the traditional qualifications for a mortgage loan and describe how each protects the lender.

ANSWER: The traditional qualifications and protections are

1. Equity in the home, in the form of a down payment for a purchase. Homeowner equity
absorbs the expenses of foreclosure and resale first. The bank loses money only after equity
is exhausted.
2. Monthly income sufficient to support the payment, usually three to four times the payment.
A homeowner who can live comfortably with his payments is less likely to default.
3. Good credit history. People with a history of paying their bills are likely to take default
seriously and make every effort to remain current on their payments.

17. What bank problems does securitization solve?

ANSWER: Securitization gives the bank liquidity because it gets its cash back immediately upon
selling the loan which it can then use to make another loan earning fees for its efforts.
 The Financial System and Interest 117

Securitization frees the bank from worry about rising short term interest rates because its
income is no longer dependent upon the spread between long and short term rates. Rather, the bank
earns its income from fees generated by making new loans.

18. What is a tranche and how was its risk estimated before the crisis.

ANSWER: A tranche is a slice of the cash coming from a pool of securitized mortgages. Risk among
tranches is determined by the sequence in which cash is applied to paying off them off. The most senior
tranche has the lowest risk because it is completely paid off before the next senior and so on down to the
most junior. Hence reductions in the cash stream from defaults effect the most junior tranche first
making them the highest risk securities. The system is based on a low default rate which implies the
senior tranches have very low risk. This proved to be a flaw when high default rates were experienced
due to subprime borrowers.

19. What factors are likely to push the reset payment up in a NegAm loan.

ANSWER: In a NegAm loan the early payments don’t cover interest and the unpaid amount is added to
principal which after (usually) five years is much higher than the original loan. The reset payment is
figured on this higher principal amortized over a period that’s five years shorter at an ARM interest rate
that may have risen since the loan’s origination.

20. Why would a rational borrower take out a NegAm loan?

ANSWER: If home prices increase rapidly over the first five years of the loan the borrower may be able
to sell or refinance before the mortgage resets realizing the appreciation as equity or profit.

21. Why did credit default swaps make the crisis worse?

ANSWER: CDSs distributed the risk of default in subprime ridden CDOs in a network that was so
complicated that financial institutions couldn’t tell who would fail next including themselves. This
made them unwilling to lend to each other because they couldn’t assess the risk of borrower default.
That slowed commerce pushing the nation into a deeper recession more quickly.

22. What was the trigger that started the crisis? If it didn’t happen would the crisis have been
averted?

ANSWER: Interest rate hikes by the Fed between 2004 and 2006 raised interest rates causing ARMs to
reset at higher rates creating payment increases that drove subprime borrowers into default. If the rate
increase didn’t happen it would likely have just delayed the meltdown as the underlying cause was the
fragility of the subprime home mortgage market which would still have been there.

23. Interest is said to drive the stock market. But interest is paid on bonds and loans while stocks
pay dividends, never interest. It would seem that interest has nothing to do with the stock market.
Explain this apparent contradiction.

ANSWER: Debt provides a generally lower risk investment alternative to stocks. Hence the return on
stock investments is always compared with the return on debt. Therefore when interest rates rise and
fall, the returns investors demand on stocks go up and down as well.

24. Discuss the similarities and differences between supply and demand for a good (product or
service) and supply and demand in a money (debt) market.
118 Chapter 5

ANSWER: The product in a debt market is loaned money rather than a commodity. Suppliers are
lenders and demanders are borrowers. Supply represents the availability of loanable funds while
demand represents the need to borrow money. The fundamental operation of supply and demand are
the same as in a commodity market, but the terminology is different. The most visible difference is on
the price axis of the S-D graph. The price of money is the interest rate. The ideas of buying and selling
are reversed. In a product market, demanders buy product which suppliers sell. In a money market
suppliers buy bonds (lend money) which demanders sell (issue).

25. Briefly explain the idea of representing an interest rate as a collection of components. What is
represented by the base rate? What is the risk premium for? Explain the idea of risk in lending.

ANSWER: Interest is the payment to someone (lender) who temporarily gives up the use of money to
another (borrower).
Giving up money involves certain actual and potential losses for the lender. The components of
interest are payments to compensate the lender for incurring the actual losses and for bearing the risk of
incurring the potential losses.
The first actual loss is whatever the money could have earned in a business investment while
loaned out. The second is the loss in purchasing power it suffers through inflation during the loan
period. Together, compensation for these losses constitutes the base rate.
Risk in lending is the chance the lender will get back less than expected (interest and principal)
when the loan was made. There are several reasons that this can happen including default, a lack of
liquidity, and price changes in the bond. Each of these reasons creates a risk for which lenders demand
compensation. Each is therefore a risk component of the interest rate.

26. Why is inflation important to lenders? How do they take it into consideration?

ANSWER: Inflation makes the principal of a loan worth less when returned than when lent. Lenders
therefore add the expected inflation rate to interest rates to avoid this loss in purchasing power.

27. Explain the nature of the potential lending losses associated with each of the following: default
risk, liquidity risk, maturity risk.

ANSWER:
Default risk - The borrower simply repays less than is due.
Liquidity risk - The lender has to get out of the loan before maturity by selling the security to another
investor. If the borrower isn't well known, the security may have to be sold at a discount.
Maturity risk - Bond prices move inversely with interest rates. If a lender has to sell a bond before
maturity, and interest rates have risen, the selling price will be less than the amount paid for the bond,

28. Do all loans have default, liquidity, and maturity risk more or less equally? Are some types of
loans relatively free of some risks? Is the debt of a particular organization free of certain risks? If so,
explain who, what, and why.

ANSWER: Default risk varies with the financial strength of the borrower. Liquidity risk varies with
the size and reputation of the borrower. US Treasury securities have zero default risk because the
government can print money. They have virtually zero liquidity risk because there's always an active
market in government debt. Maturity risk varies with term, and all debt securities of a given term have
essentially the same maturity risk.

29. Explain the ideas of a risk-free rate and the real rate of interest. Are either of them
approximated by anything that exists in the real world?
 The Financial System and Interest 119

ANSWER: The risk-free rate is the rate on a loan without default, liquidity, or maturity risk. The real
rate is an actual rate less the inflation adjustment. The risk free rate is generally taken to be the yield
on short-term treasury securities.

30. What is a yield curve? Briefly outline three theories that purport to explain its shape. How
does the yield curve influence the behavior of lenders?

ANSWER: The yield curve is a graph of the relation between the terms of loans and their interest
rates.
The market segmentation theory says that there are independent markets with different supply
and demand conditions for loans of different terms. Therefore, the yield curve can slope up or down
depending on the availability of and demand for funds in each of those markets.
The expectations theory says that expectations of higher or lower rates in the future (perhaps
due to higher or lower inflation) cause the yield curve to slope up or down.
The liquidity preference theory says that all other things equal, lenders prefer shorter loans and
therefore demand liquidity premiums for longer terms which makes the yield curve slope upward.
The yield curve tends to define the rates lenders demand as a function of term.

BUSINESS ANALYSIS

1. Harry, a friend of yours, is taking a course in economics, and has become confused by some of
the terminology because of the way people commonly use the same words. The economics professor
says investment occurs when companies buy equipment and build factories. Yet Harry has always
heard people talk about investing as a method of saving when they put money in the bank or purchase
securities. He's confused by these dissimilar uses of the word, and has asked you to explain. After
asking for your help, Harry happily states that there's one thing he does understand perfectly about what
the econ prof says, and that is "savings equals investment." Since investing in stocks and bonds is also
saving money, it's obvious that savings equals investment! Write a brief explanation to help Harry out.

ANSWER: The term investment means spending money in a way that will make the future better
rather than spending it on current consumption.
When companies do that they buy assets and build factories to produce more in the future for a
larger profit. When people do it they buy financial assets that earn a return which can be spent along
with the original investment making them better off in the future.
People invest in financial assets with money they save by not spending it on things they'll
consume right away. So an individual's savings does equal his or her investment. However, that's not
what the professor means. He or she is referring to the fact that business investment comes from money
raised through the sale of securities that are purchased by individuals with their savings. Hence the
money available in the economy for business investment can be no more than the amount saved by
individuals. Hence nationwide, savings (of individuals) equals investment (of businesses).

2. Brokers and mutual funds do the same thing, invest your money for you. Is that statement true
or false? Explain. What kind of financial institution is a mutual fund? What is its distinguishing
feature? Describe how savings banks and insurance companies are similar to mutual funds.

ANSWER: False. Although both invest your money for you the mechanics are different. The broker
passes your money through to the recipient in return for a security that is passed back to you. The
mutual fund is a financial intermediary that pools your money with that of other investors and buys
securities which it retains issuing you a share of itself. The distinguishing feature of the financial
intermediary (mutual fund) is that it issues the investor its own security, i.e. a claim on itself. The
broker doesn't do that. In other words, the fund owns securities and is in turn owned by investors.
120 Chapter 5

3. Sharon Jacobs is CEO of Henderson Industries Inc, a public company. Henderson makes heavy
construction equipment like bulldozers and cranes which it sells to small construction companies.
These customers are generally in poor financial condition and must finance their purchases with banks
or finance companies. Unfortunately lenders have had increasing trouble collecting on their loans. As
many as thirty percent of customers default, requiring the lenders to repossess and resell the equipment.
This usually avoids a loss, but it’s an administrative hassle. Because of the ups and downs of the
construction industry, it is impossible at the time of sale to predict which customers will default.
The economy is going downhill at present and Henderson has been experiencing financial
difficulties itself. The company’s problems are reflected in its stock price which has declined forty
percent over the last two years on weakening sales.
In order to boost sales, Henderson would like to sell to new customers that are financially even
weaker than its current customers. Unfortunately the banks and finance companies won’t lend to even
weaker borrowers. As a result, Henderson is considering offering product to these new customers on
deferred payment terms. That means it will receive a stream of monthly payments over two or three
years until the equipment is paid off. Defaults on this new business will probably be worse than the
finance companies are now experiencing but no one knows by how much. The good news, however, is
that Sharon thinks she can sell a lot of equipment to these new customers.
On top of all this, the deferred payment idea presents an accounting issue. Typically when a
sale is made, the entire price of the product along with its cost are recognized on the income statement at
the time of sale. Any unpaid money is carried as a receivable regardless of how long the customer has
to pay.
BUT if there are serious questions about collecting the deferred payments, it’s more appropriate
to use the installment sales method which recognizes revenue and a pro rata portion of cost only as cash
is received from customers.
What ethical issues does Sharon face with respect to disclosure of financial information
including but not limited to the income statement.
Suppose Sharon has stock options and/or a bonus package that depend on stock price. How
might her compensation plan affect her decisions.

ANSWER: There are two big issues in Henderson’s (and Sharon’s) situation. The first is whether to
disclose the deferred payment plan to stockholder and the second is how to account for the sales.
It’s important to understand exactly what Henderson would be doing under the new plan. It
would essentially be lending money to its customers to buy its equipment. If times really get tough in
the construction industry, a large percentage of the new customers may not repay that debt. At the same
time there may be no market for the repossessed machinery. That would mean Henderson will have
given away its product for nothing which will lead to a giant loss and perhaps failure.
If Henderson openly discloses the deferred payment plan to investors, they will probably react
negatively and bid the stock’s price down even further. If it isn’t disclosed, little is likely to happen
until the program is discovered, probably when defaults begin. That’s likely to lead to investor outrage
and a precipitous drop in stock price.
The accounting treatment of the program is the more interesting question. If the appropriate
installment sales technique is used, sales under the new program will have little impact on this year’s
revenue and profit because only a small fraction of each sale will be paid and recognized in the current
year. Hence the financial statements won’t change investors’ attitudes about the company and stock
price will probably continue to decline.
But if the traditional accounting treatment is used, the entire revenue and profit from every
piece of new equipment sold under the program will appear on this year’s income statement. That will
happen despite the fact that much of that revenue and profit is likely to be reversed in future years. The
big increase in revenue and profit will probably fool unsophisticated investors into thinking the firm has
been turned toward profitability and cause them to bid its stock price up substantially. Unfortunately,
giving that impression would be deceptive and misleading as the firm is really in worse shape than ever.
 The Financial System and Interest 121

If Sharon has a bonus plan tied to stock price and/or stock options, she would be very tempted
to use the traditional accounting method, even though it’s inappropriate, because doing so would have a
very positive impact on her personal wealth. In other words, the situation represents a moral hazard for
Sharon.
The firm’s auditors should refuse to certify Henderson’s books as complying with GAAP if the
company doesn’t use the installment sales method. However, one would expect Sharon to be tempted to
be as persuasive as possible in attempting to convince the auditors that collections aren’t as risky as they
appear and to use the more aggressive approach.
It’s important to realize that issues like this usually aren’t entirely clear. Deciding just how
collectable deferred revenue will be requires a subjective judgment, and it isn’t entirely unreasonable to
argue that the traditional accounting treatment is more appropriate.

4. Does the so-called risk free rate actually have some risk? (This is a tough question that isn't
discussed in the chapter. Think about what makes up the risk-free rate and what among those pieces is
an estimate of the future.)

ANSWER: The risk-free rate has inflation risk which arises from changes in purchasing power as a
result of unanticipated inflation. For example, if the inflation adjustment in a loan is 5%, but actual
inflation turns out to be 7%, the lender will end up with less purchasing power than expected even if the
loan and interest are fully paid.

5. Your Aunt Sally has a large portfolio of corporate bonds of different maturities. She has asked
your advice on whether to buy more or get rid of some. You anticipate an increase in interest rates in
the near future. How would you advise her? Would your advice depend on the maturity of individual
bonds?

ANSWER: If interest rates rise, bond prices will fall. If you're sure rates are going to rise it certainly
wouldn't make sense to buy more bonds now. It might even be a good idea to sell bonds now and buy
them back later at lower prices. This is especially true of longer maturity issues whose prices will
change more than shorter-term issues due to the interest rate change. This would be risky advice
because no one ever can be sure of interest rate movements.

PROBLEMS

1. Refer to the Microsoft stock quotation on page 194. Demonstrate that the price earnings (P/E) ratio
is consistent with other information in the listing.

SOLUTION:
The P/E ration is the ratio of the ratio of the current price to earnings per share (EPS).
P/E = Price / EPS = $27.91 / $2.75 = 10.15

The small difference between that and the listing of 10.14 is due to rounding in the EPS figure.

Executive Stock Options – Example 5.1 (page 193)

2. Sam Lawson is a vice president at a large communications firm. His compensation includes a salary
of $400,000, a bonus of $200,000 and a stock option package that allows him to purchase 30,000 shares
of the company’s stock at $45 per share. He can exercise the option anytime within a three year period
that starts on the first of next month. The stock is now selling at $62.50 per share. If the current price
holds until the first of the month, and Sam exercises his option, how much will he make this year?
122 Chapter 5

SOLUTION:
Sam will buy his stock at the option price of $45 paying a total of
$45 x 30,000 = $1,350,000
He will then sell his shares for
$62.50 x 30,000 = $1,875,000
And his net gain will be
$1,875,000 - $1,350,000 = $525,000
Which will give Sam total compensation of
$400,000 + $200,000 + $525,000 = $1,125,000

3. Read Business Analysis Case 3. Henderson Industries Inc.’s stock is currently selling at $22.40 per
share. Sharon Jacobs, the CEO, has options to buy 250,000 shares at $25.50 per share that expire at the
end of this year. Sharon feels that if the traditional accounting method is used, implementing the
deferred payment sales program will push the stock’s price about half way toward the level it was at two
years ago which was about $43.00. (That method recognizes the entire price and cost of a sold item on
the income statement at the time of sale.) If the installment sales technique is used the price of the stock
will probably be unchanged but may even go down a little.
How much will Sharon make on her stock option if she can pressure Henderson’s auditors into
allowing the traditional method.

SOLUTION:
Half way to the former price is
($43.00 - $22.40) / 2 = $20.60 / 2 = $10.30
Likely price with program
$22.40 + $10.30 = $32.70
Per share gain on stock options
$32.70 - $25.50 = $7.20
Total gain
$7.20 x 250,000 = $1.8 million

A Moral Hazard for Founders – Concept Connection Example 5.2 (page 195)
4. If Sharon Henderson of the previous problem is also a founder of the company and has retained 8
million shares of its stock, how much of a difference will the auditors’ decision make in her personal
wealth outside of the stock option?

SOLUTION:

The decision involves a price change of $10.30 which will apply to all of Sharon’s shares so it will
impact her wealth by

8 million x $10.30 = $82.4 million.

Using the Interest Rate Model – Example 5.3, (page 219)

5. Nu-Mode Fashions Inc. manufactures quality women’s wear, and needs to borrow money to get
through a brief cash shortage. Unfortunately, sales are down, and lenders consider the firm risky. The
CFO has asked you to estimate the interest rate Nu-Mode should expect to pay on a one year loan.
She’s told you to assume a 3% default risk premium even though the loan is relatively short, and to
assume the liquidity and maturity risk premiums are each ½%. Inflation is expected to be 4% over the
next twelve months. Economists believe the pure interest rate is currently about 3½%.
 The Financial System and Interest 123

Solution: Write the interest rate model and substitute. Since the loan is for one year, the inflation
adjustment is simply the expected inflation rate for the year.
k = kpr + INFL + DR + LR + MR
k = 3.5 + 4.0+ 3.0 + .5 + .5
k = 11.5%

6. Calculate the rate Nu-Mode in the last problem should expect to pay on a two year loan. Assume a
4% default risk premium and liquidity and maturity risk premiums of ¾% due to the longer term.
Inflation is expected to be 5% in the loan’s second year.

Solution: First calculate the inflation premium as the average inflation rate over the life of the loan.
INFL = (4 + 5)/2 = 4.5%
Then write the interest rate model and substitute.
k = kpr + INFL + DR + LR + MR
k = 3.5 + 4.5+ 4.0 + .75 + .75
k = 13.5%

7. Keena is saving money so she can start a two year graduate school program two years from now. She
doesn’t want to take any chances going grad school, so she’s planning to invest her savings in the lowest
risk securities available, Treasury notes (short-term bonds). She will need the first year’s tuition in two
years and the second year’s in three. Use the interest rate model to estimate the returns she can expect
on two and three year notes. The inflation rate is expected to be 4% next year, 5% in the following year,
and 6% in the year after that. Maturity risk generally adds .1% to yields on shorter term notes like these
for each year of term. Assume the pure rate is 1.5%.

SOLUTION:
Treasury securities have no liquidity or default risks, so the interest rate model becomes
k = k* + INFL + MR

INFL for a two year note: (4% + 5%) / 2 = 4.5%

INFL for a three year note: (4% + 5% + 6%) / 3 = 5.0%

MR for a 2 year note is .2% and for a 3 year note is .3%

Substituting:

Two year note: k = 1.5% + 4.5% + .2% = 6.2%

Three year note: k = 1.5% + 5.0% + .3% = 6.8%

8. Adams Inc. recently borrowed money for one year at 9%. The pure rate is 3%, and Adams’ financial
condition warrants a default risk premium of 2% and a liquidity risk premium of 1%. There is little or
no maturity risk in one-year loans. What inflation rate do lenders expect next year?

Solution: Use the interest rate model to calculate the inflation adjustment.
k = kpr + INFL + DR + LR + MR
9 = 3 + INFL + 2 + 1 + 0
INFL = 3%
Since the loan is for one year, the inflation adjustment equals the expected inflation rate for the year.

9. Mountain Sports Inc borrowed money for two years last week at 12%. The pure rate is 2%, and
Mountain’s financial condition warrants a default risk premium of 3% and a liquidity risk premium of
124 Chapter 5

2%. The maturity risk premium for two year loans is 1%. Inflation is expected to be 3% next year.
What does the interest rate model imply the lender expects the inflation rate to be in the following year?

SOLUTION: First solve the interest rate model for the inflation adjustment under the assumptions
given.
k = kpr + INFL + DR + LR + MR
12 = 2 + INFL + 3 + 2 + 1
INFL = 4%
The inflation adjustment is the average inflation rate over the two year life of the loan. Letting I1 and I2
be the inflation rates in years one and two we have
INFL = (I1 + I2) / 2
Substituting I1 = 3 and INFL = 4 we have
4 = (3 + I2) / 2
I2 = 5%

10. The Habender Company just issued a two-year bond at 12%. Inflation is expected to be 4% next
year and 6% the year after. Habender estimates its default risk premium at about 1.5% and its maturity
risk premium at about .5%. Because it's a relatively small and unknown firm, its liquidity risk
premium is about 2% even on relatively short debt like this. What pure interest rate is implied by these
assumptions?

SOLUTION: Write the interest rate equation and substitute, noting that
INFL = (4% + 6%) / 2 = 5%
then
k = kPR + INFL + DR + LR + MR
12% = kPR + 5% + 1.5% + 2% + 0.5%
kPR = 3%

11. Charles Jackson, the founder and president of the Jackson Company is concerned about his firm’s
image in the financial community. The concern arose when he went to the bank for a one year loan and
was quoted a rate of 12% which was considerably more than the firm had been paying recently. He’s
asked you, the treasurer, for an analysis that could shed some light on what might be causing the bank to
ask for such a high rate.
Your research indicates the following. The economy is stable with a 3% inflation rate that isn’t
expected to change in the near future. The local banking community consistently considers the pure
interest rate to be about 4%. Liquidity risk for companies of Jackson’s size and reputation is generally
not more than 1%, and maturity risk is virtually zero for one year loans. In the past Jackson’s reputation
has warranted a low default risk premium of 2%. The firm’s financial condition has been stable for
some time. Two months ago Jackson had a major dispute with one of its suppliers. Charles refused to
pay for a large shipment due to poor quality. The vendor did not agree and claimed that Jackson was
just using the quality issue to avoid paying its bills. (Hint: Suppose the vendor reported the dispute to a
credit agency.)

SOLUTION: The bank’s estimate of kpr, INFL, LR, and MR aren’t likely to have changed, hence the
bank’s quoted rate implies a default risk that can be calculated as follows.
k = kpr + INFL + DR + LR + MR
12 = 4 + 3 + DR + 1 + 0
DR = 4%
This is a big increase over the previous 2% indicating that the bank may have heard about the dispute
with the vendor and be concerned over Jackson’s willingness to pay its obligations.
 The Financial System and Interest 125

12. Use the interest rate model to solve the following problem. One-year treasury securities are yielding
12% and two-year treasuries yield 14%. The maturity risk premium is zero for one-year debt and 1%
for two-year debt. The real risk-free rate is 3%. What are the expected rates of inflation for the next
two years? (Hint: Set up a separate model for each term with the yearly inflation rates as unknowns.)

SOLUTION: Let I1 and I2 be the expected inflation rates in years one and two. Then write
k = kPR + INFL + DR + LR + MR
for each term with DR and LR zero for treasury securities.
k1 = kPR + I1 + MR1
k2 = kPR + (I1+I2)/2 + MR2

The real, risk free rate is just kPR = 3% so the first equation gives
I1 = 9%.
Substituting into the second equation then gives
14% = 3% + (9%+I2)/2 + 1%
From which
I2 = 11%.

13. Inflation is expected to be 5% next year and a steady 7% each year thereafter. Maturity risk
premiums are zero for one year debt but have an increasing value for longer debt. One-year government
debt yields 9% whereas two-year debt yields 11%.
a. What is the real risk-free rate and the maturity risk premium for two-year debt?
b. Forecast the nominal yield on one- and two-year government debt issued at the beginning of
the second year.

SOLUTION: a. For one-year government debt

k1 = kPR + I1 + MR1
9% = kPR + 5% + 0%
kPR = 4%

Then for two-year government debt

k2 = kPR + (I1+I2)/2 + MR2
11% = 4% + 6% + MR2
MR2 = 1%

b. k1 = kPR + I2
= 4% + 7% = 11%
k2 = kPR + (I2 + I3)/2 + MR2
= 4% + 7% +1%
= 12%

Using the Interest Rate Model Over a Range of Terms – Example 5.4, Page 220
14. Economists have forecast the following yearly inflation rates over the next 10 years:
Year Inflation Rate
1 3.0
2 2.5
3-6 4.0
7-10 3.0
Calculate the inflation components of interest rates on new bonds issued today with terms
varying from one (1) to ten (10) years.

SOLUTION:
126 Chapter 5

1-year = 3.0%
2-year = (3 + 2.5)/2 = 2.75%
3-year = (3 + 2.5 + 4)/3 = 3.17%
4-year = (3 + 2.5 + 4 + 4)/4 = 3.38%
5-year = (3 + 2.5 + 4 + 4 + 4)/5 = 3.50%
6-year = (3 + 2.5 + 4 + 4 + 4 + 4)/6 = 3.58%
7-year = (3 + 2.5 + 4 + 4 + 4 + 4 + 3)/7 = 3.50%
8-year = (3 + 2.5 + 4 + 4 + 4 + 4 + 3 + 3)/8 = 3.44%
9-year = (3 + 2.5 + 4 + 4 + 4 + 4 + 3 + 3 + 3)/9 = 3.39%
10-year = (3 + 2.5 + 4 + 4 + 4 + 4 + 3 + 3 + 3 + 3)/10 = 3.35%

15. The interest rate outlook for Montrose Inc., a large, financially sound company, is reflected in the
following information:
(1) The pure rate of interest is 4%.
(2) Inflation is expected to increase in the future from its current low level of 2%. Predicted
annual inflation rates follow:

Year Inflation Rate

1 2%
2 3%
3 4%
4 5%
5-20 6%

(3) The default risk premium will be .1% for one-year debt, but will increase .1% for each
additional year of term to a maximum of 1%.
(4) The liquidity premium is zero for one and two-year debt, .5% for three-, four-, and five-year
terms and 1% for longer issues.
(5) The maturity risk premium is zero for a one-year term and increases by .2% for each
additional year of term to a maximum of 2%.
a. Use the interest rate model to estimate market rates on the firm's debt securities of the
following terms: 1 to 5 years, 10 years, and 20 years.
b. Plot a yield curve for the firm's debt.
c. Using different colors on the same graph, sketch yield curves for
(i) federal government debt and
(ii) Shaky Inc., a firm currently in financial difficulty.
d. Explain the pattern of deviation from Montrose's yield curve for each of the others.

SOLUTION: a. First, calculate the inflation adjustment as the average inflation rate over each term:
Year Inflation Rate Inflation Adjust.
1 2.0% 2.0%
2 3.0% 2.5%
3 4.0% 3.0%
4 5.0% 3.5%
5 6.0% 4.0%
10 6.0% 5.0%
20 6.0% 5.5%
Next, create a table with a column for each of the elements of interest rate model, fill in each
column, and add across.
Term kPR + INFL + DR + LR + MR = k
1 4.0 2.0 0.1 0.0 0.0 6.1%
2 4.0 2.5 0.2 0.0 0.2 6.9%
 The Financial System and Interest 127

3 4.0 3.0 0.3 0.5 0.4 8.2%

4 4.0 3.5 0.4 0.5 0.6 9.0%
5 4.0 4.0 0.5 0.5 0.8 9.8%
10 4.0 5.0 1.0 1.0 1.8 12.8%
20 4.0 5.5 1.0 1.0 2.0 13.5%

b., c.

k%
14.0
13.0 //
12.0
11.0
10.0 Shaky
9.0 //
8.0
7.0 //
6.0 Fed

1 2 3 4 5 // 10 // 20

Term in Years

d. The government's plot is below Montrose's because it is safer and has no default or liquidity
premiums. The spread between the government and Montrose widens as term grows longer because the
firm has little short-term risk (it's in sound financial condition), but in the long run any firm can get into
trouble. Shaky is always above Montrose because of its higher risk.

16. Atkins Company has just issued a series of bonds with 5- through 10-year maturities. The
company’s default risk is 0.5% on 5-year bonds, and grows by 0.2% for each year that’s added to the
bond’s term. Atkins’ liquidity risk is 1.0% on 5-year bonds, and grows by 0.1% for each additional year
of term. Maturity risk on all bonds is 0.2% on 1-year bonds, and grows by 0.1% for each additional
year of term. What is the difference between the interest rates on Atkins’ bonds and those on federal
government bonds of like terms?

SOLUTION:
The real risk free rate, inflation and maturity risk are equal in Atkins and federal bonds. Hence,
the difference in interest rates is just the sum of Atkins’ default and liquidity risks which are not
shared by the federal issues.

Term Default Risk Liquidity Risk Total Difference

128 Chapter 5

5-year 0.5% 1.0% 1.5%

6-year 0.7% 1.1% 1.8%
7-year 0.9% 1.2% 2.1%
8-year 1.1% 1.3% 2.4%
9-year 1.3% 1.4% 2.7%
10-year 1.5% 1.5% 3.0%

17. Assume that interest rates on federal government bonds are as follows:
1-year 6.5%
2-year 6.3%
3-year 6.0%
4-year 5.8%
5-Year 5.5%
10 year 5.2%
15-year 5.0%
20-year 5.0%
Do the theories of the shape of the yield curve offer any insights into this rate pattern? Discuss
the expectations, liquidity preference, and market segmentation theories separately. Words only.

SOLUTION:
Interest rates are dropping over the entire 20-year period. The expectations theory
suggests this is because people generally expect that inflation rates will drop substantially in the
future. Indeed the inflation rate drop must be enough to overcome any increasing maturity risk
premium assigned to the bonds.
Liquidity preference says that lenders always have to be enticed by higher interest rates
in order to lend for longer periods of time. The liquidity preference theory therefore suggests
that something is overcoming that effect, probably an expectation of falling inflation rates.
The market segmentation theory suggests that proportionately more long-term money is
available in debt markets than short-term money relative to the amounts being demanded. In
other words, there’s a lot of supply and not much demand for long-term debt right now. But in
short-term debt markets it’s just the opposite, there’s a lot of demand but not much supply.
That tends to push interest, the price of borrowed money, down in long-term markets and up in
short-term markets.

18. The real risk free rate is 2.5%. The maturity risk premium is 0.1% for 1-year maturities, growing by
0.2% per year up to a maximum of 1.0%. The interest rate on 4-year treasuries (federal government
bonds) is 6.2%, 7.5% on 8-year treasuries and 8.0% on 10-year treasuries. What conclusions can be
drawn about expected inflation rates over the ten-year period?

SOLUTION:
First, we need to calculate the inflation component of the 8-year and 10-year treasuries. The
maturity risk premium will be 0.7% on 4-year treasuries and 1.0% on both 8- and 10-year
treasuries. By subtraction, we can determine the inflation component:
4-year: INFL = 6.2% - 2.5% - 0.7% = 3.0%
8-year: INFL = 7.5% - 2.5% - 1.0% = 4.0%
10-year = INFL = 8.0% - 2.5% - 1.0% = 4.5%
We can conclude that inflation will average 3.0% over the first four years.
In order for the “average” inflation rate to be 4.0% over eight years, the average inflation for
years 5-8 would have to be 5.0%
[(4 x 3.0%) + (4 x 5.0%)] /8 = 4.0%
In like manner for average inflation to be 4.5% over ten years, the average inflation rate in
years 9 and 10 would have to be 6.5%.
 The Financial System and Interest 129

[(8 x 4.0%) + (2 x 6.5%)]/10 = 4.5%