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Chapter 01 - The Investment Setting

Solution Manual for Fundamentals of

Investment Management 10th Edition by
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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?

1-1
Chapter 01 - The Investment Setting

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.

1-2
Chapter 01 - The Investment Setting

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).

1-3
Chapter 01 - The Investment Setting

13. Many people think of risk as the danger of losing money. Is this the same way that risk
is defined in finance?

1-13. In finance, risk is not viewed as simply the danger of losing money, but rather as the
uncertainty associated with the outcomes from an investment. The greater the dispersion
of possible outcomes, the greater is the risk.

14. What are the three elements that determine the return an investor should require from
an investment?

1-14. The three elements that determine required return are: the real rate of return, the
anticipated inflation factor, and the risk premium.

15. Explain how an investor receiving a 2 or 3 percent quoted return in an inflationary

environment may actually experience a negative real rate of return.

1-15. If the rate of inflation exceeds the quoted rate of return on an investment, the investor
will experience a negative real return. He or she is "paying" the borrower to use the
funds. 1-16. In Figure 1-4, the Ibbotson values show that the highest return category
was small company stocks and the lowest was U.S. Treasury Bills. Not coincidentally,
small stocks had the highest risk and Treasury bills the lowest risk.

16. In Figure 1–4, what has been the highest return investment category over the 79-year
period? What has been the lowest? Assuming risk is measured by the standard
deviation, what can you say about the relationship of risk to return in Figure 1–4?

1-16. In Figure 1-4, the Ibbotson values show that the highest return category was small
company stocks and the lowest was U.S. Treasury Bills. Not coincidentally, small stocks
had the highest risk and Treasury bills the lowest risk.

PROBLEMS

Rate of return
1. The price of the stock of Clarkson Corporation went from $50 to $56 last year. The firm
also paid $2 in dividends. Compute the rate of return.

(P1 − P0 ) + D1
1-1. Rate of return =
P0

($56 − $50) + $2 $6 + $2 $8
= = =16%
$50 $50 $50

1-4
Chapter 01 - The Investment Setting

Rate of return

2. In the following year, the dividend was raised to $2.25. However, a bear market developed
toward the end of the year, and the stock price declined from $56 at the beginning of the
year to $48 at the end of the year. Compute the rate of return or (loss) to stockholders.

($48 − $56) + $2.25 −$8 + $2.25 −$5.75

1-2. = = = −10.27%
$56 $56 $56

Risk-free rate
3. Assume the real rate of return in the economy is 2.5 percent, the expected rate of inflation
is 5 percent, and the risk premium is 5.8 percent. Compute the risk-free rate (Formula 1-3)
and required rate of return.

1-3. Risk-free rate = (1 + Real rate)  (1 + Expected rate of inflation) – 1

(1.025)(1.05) − 1 = 1.0763 − 1 = .0763 = 7.63%

Required rate of return = Risk-free rate + Risk premium

= 7.63% + 5.8%

= 13.43%

Required return
4. Assume the real return in the economy is 4 percent. It is anticipated that the consumer price
index will go from 200 to 210. Shares in common stock are assumed to have a required
return one-third higher than the risk-free rate. Compute the required return on common
stock.

1-4. Real rate = 4.0%

Expected rate of inflation = 210/200 = 1.05 or 5%

The risk-free rate is:

(1.04)(1.05) −1 = 1.092−1 = .092 = 9.2%

The required rate of return is:

9.2%  1.33 = 12.24%

1-5
Chapter 01 - The Investment Setting

Geometric return
5. Sally is reviewing the performance of several portfolios in the family trusts. Trust A is
managed by Wall Street Investment Advisors and Trust B is managed by LaSalle Street
Investment Advisors. Both trusts are invested in a combination of stocks and bonds and
have the following returns:

Trust A Trust B
Year 1 15% 12%
Year 2 10 15
Year 3 -4 -2
Year 4 25 20
Year 5 -8 -5

a. Calculate the annualized geometric and arithmetic returns over this 5-year period.
b. Which manager performed the best, and is there a significant enough difference for Sally to
move her money to the winning manager?
c. Explain the difference between the geometric and arithmetic returns.

Geometric return R G = √(1 + r1 )(1 + r2 )(1 + r3 ) ··· (1 + rn ) − 1

n
1-5. a)
5
Geometric return of Trust A = √(1 + 15%)(1 + 10%)(1 − 4%)(1 + 25%)(1 − 8%） − 1
= 6.91%

Geometric return of Trust B = √(1 + 12%)(1 + 15%)(1 − 2%)(1 + 20%)(1 − 5%) − 1

5

= 7.55%

(1+r1 )(1+r2 )(1+r3 ) ··· (1+rn )

Arithmetic return R A = n

15%+10%−4%+25%−8%
Arithmetic return of Trust A = = 7.60%
5

12%+15%−2%+20%−5%
Arithmetic return of Trust B = = 8%
5

b) Trust B performed the best as both the geometric return and arithmetic return of Trust B
are better than those of Trust A.
We have to consider whether the two portfolios have equal risk and not just consider the
2
return. The Standard deviation is a measure of the risk and the standard deviation =√Var.
The standard deviation of Trust A is 13.61 and the standard deviation of Trust B is 10.93.
Thus the standard deviation of Trust B is lower than Trust A, which means Trust B
provided a better return with a lower risk. So there is a significant enough difference for
Sally to move her money to the Trust B.

1-6
Chapter 01 - The Investment Setting

c) The arithmetic mean return best represents the mean return in a single period and has an
upward bias when negative returns are included in the return series. The geometric mean
return best represents the compound rate of return and does not provide any upward bias
when negative numbers are included in the return series. The geometric mean is the most
accurate method for determining investment returns.

Capital asset pricing model

6. Calculate the required rate of return for Campbell Corp. common stock. The stock has a
beta of 1.3 and Campbell is considered a large capitalization stock. Current long-term
government bonds are yielding 5.0%. (Refer to table 1-3 for equity risk premiums of
large stocks).

For CAPM, the required rate of return = Risk-free rate + Beta * Equity Risk premium
Using Table 1-3 for historical equity risk premiums we find an equity risk premium of 4.4%
when long-term government bonds are compared to large common stock returns.

The required rate of return for Campbell Corp. = 5.0% + 1.3*4.4% = 9.97%

a. How would your required rate of return change if you used U.S. Treasury bills for your
risk-free rate? Assume the current yield on T-bills is 1.25 percent. This is an artificially
low rate because the Federal Reserve is trying to stimulate the economy out of a recession.
1-6. a)
The risk-free rate changes from 5.0% to 1.25% so the market risk premium changes from
4.4% to 6.1%. So the required rate of return for Campbell Corp. is (1.25%+1.3*6.1%) =
9.18%.

b. How would this difference in required returns affect the value of any cash flow you would
evaluate?

1-6. b)
The required rate of return for Campbell Corp decreases from 9.97% to 9.18% if we use
the current yield on T-bills instead of the yield to maturity on long-term government
bonds. The decrease in the required rate of return will increase the value of any cash flow
we would evaluate when we use the required rate of return to discount future cash flows.

Capital asset pricing model

7. Fastchip is a small technology company with a beta of 1.5 and a market capitalization of
$200 million. Currently, long-term government securities are yielding 5.0 percent,
intermediate governments are yielding 4.0 percent, and T-bills are yielding 3.3 percent.
Calculate the required rate of return using all three risk-free rates. Choose which one would
be the most aggressive and which would be the most conservative to use in valuing cash
flows. Which K e would you prefer to use, and why? (Refer to Table 1-3 for equity risk
premiums using the small stock returns).

1-7
Chapter 01 - The Investment Setting

For CAPM, the required rate of return = Risk-free rate + Beta * Equity Risk premium

Choosing the long-term government securities yield 5.0% as the risk-free rate,
The required rate of return for Fastchip K e1 = 5.0%+1.5*6.5% = 14.75%

Choosing the intermediate governments yield 4.0% as the risk-free rate, so the equity risk
premium is 4.5%,
The required rate of return for Fastchip K e2 = 4.0%+1.5*6.6% = 13.9%

Choosing the T-bills yield 3.3% as the risk-free rate, so the equity risk premium is 6.1%,
The required rate of return for Fastchip K e3 = 3.3%+1.5*8.2% = 15.6%

K e2 is 13.9% and has the lowest required rate of return so it would be the most aggressive and
create the highest value. K e3 is 15.6% and has the highest required rate of return so it would
be the most conservative and create the lowest value of the cash flows.

If the investor wanted to be conservative in his or her valuation of the company K e3 would
generate the lowest value. One possible lesson to learn is that single point value estimates
may give a false sense of confidence in the final value. Perhaps the investor could value the
company using all three required returns and generate a high-low-average range of values. If
the current stock price falls within the range of values, it could be fairly priced.

1-8
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The Project Gutenberg eBook of It might have
been worse
 This ebook is for the use of anyone anywhere in the United
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Title: It might have been worse

a motor trip from coast to coast

Author: Beatrice Larned Massey

Release date: September 19, 2023 [eBook #71685]

Language: English

Original publication: San Francisco: Harr Wagner Publishing Co,

1920

Credits: Peter Becker and the Online Distributed Proofreading

Team at https://www.pgdp.net (This file was produced
from images generously made available by The
Internet Archive)

*** START OF THE PROJECT GUTENBERG EBOOK IT MIGHT

HAVE BEEN WORSE ***
 Transcriber’s Note
A much larger, higher-resolution version of the map may
be seen by clicking or right-clicking "(Larger)" beneath it.
Additional notes will be found near the end of this ebook.
 (Larger)
IT MIGHT HAVE BEEN WORSE
KEY
~~~~~~~ ROUTE FOLLOWED BY CAR
- - - - CAR SHIPPED BY BOAT OR TRAIN
—o— TOWNS VISITED, OR EN ROUTE
☉ OVER NIGHT STOPS
it might have been worse
 IT
MIGHT HAVE BEEN
WORSE
A MOTOR TRIP FROM COAST
TO COAST
BY
BEATRICE LARNED MASSEY

SAN FRANCISCO
HARR WAGNER PUBLISHING CO.
MCMXX
Copyright, 1920, By Beatrice Larned Massey
Printed by Taylor & Taylor, San Francisco
TO MY DEAR MR. NIP
 CONTENTS

chapter page
i. the start 1
ii. new york to pittsburgh 6
iii. ohio and detours 20
iv. on to chicago 30
v. through the dairy country 39
vi. clothes, luggage, and the car 43
vii. the twin cities and ten thousand
lakes 54
viii. millions of grasshoppers 62
ix. the bad lands—“nature’s
freakiest mood” 70
x. the dust of montana 77
xi. a wonderland 87
xii. westward ho! 103
xiii. nevada and the desert 117
xiv. the end of the road 130
 FOREWORD

May I state, at the start, that this account of our motor trip from
New York City to San Francisco is intended to be not only a road
map and a motor guide for prospective tourists, but also to interest
the would-be or near motorists who take dream trips to the Pacific? It
sounds like a rather large order, to motor across this vast continent,
but in reality it is simple, and the most interesting trip I have ever
taken in our own country or abroad.
There are so many so-called “highways” to follow, and numerous
routes which, according to the folders, have “good roads and first-
class accommodations all the way” that hundreds of unsuspecting
citizens are touring across every year. I can speak only for
ourselves, and will doubtless call down the criticism of many who
have taken any other route. On the whole, it has been a revelation,
and, to my mind, the only way to get a first-hand knowledge of our
country, its people, the scenery, and last, but not the least, its roads
good, bad, and infinitely worse.
B. L. M.
San Francisco, January, 1920
IT MIGHT HAVE BEEN WORSE
 IT
MIGHT HAVE BEEN
WORSE

THE START

After reading “By Motor to the Golden Gate,” by Emily Post,

published in 1916, I was fired by a desire to make a similar tour. This
desire grew into a firm determination the more I re-read her
charming book. Then the United States went into the war, and self-
respecting citizens were not spending months amusing themselves;
so all thought of the trip was put aside until the spring of this year
(1919). Then the “motor fever” came on again, and refused to yield
to any sedatives of advice or obstacles. After talking and planning for
three years, we actually decided to go in ten minutes—and in ten
days we were off. All the necessary arrangements were quickly
made; leasing our home, storing our household goods, closing up
business matters, getting our equipment and having the car
thoroughly looked over, and all the pleasant but unnecessary duties
occupied the last few days. Why will people write so many letters
and say so many good-bys, when a more or less efficient mail and
telegraph service circles our continent? But it is the custom, and all
your friends expect it—like sending Easter and Christmas cards by
the hundreds. We are victims of a well-prescribed custom.
It is always of interest to me to know the make of car that a
friend (or stranger) is driving; so let me say, without any desire to
advertise the Packard, that we had a new twin-six touring car, of
which I shall speak later on. I believe in giving just tribute to any car
that will come out whole and in excellent condition, without any
engine troubles or having to be repaired, after a trip of 4154 miles
over plains and mountains, through ditches, ruts, sand, and mud,
fording streams and two days of desert-going. And let me add that
my husband and I drove every mile of the way. It is needless to say
that the car was not overstrained or abused, and was given every
care on the trip. In each large city the Packard service station
greased and oiled the car, turned down the grease-cups, examined
the brakes and steering-gear, and started us off in “apple-pie” order,
with a feeling on our parts of security and satisfaction.
The subject of car equipment, tires, clothes, and luggage will
take a chapter by itself. But let me say that we profited in all these
regards by the experience and valuable suggestions of Mrs. Post in
her book.
When we first spoke to our friends of making this trip, it created
as little surprise or comment as if we had said, “We are going to tour
the Berkshires.” The motor mind has so grown and changed in a few
years. Nearly everyone had some valuable suggestion to make, but
one only which we accepted and profited by. Every last friend and
relative that we had offered to go in some capacity—private
secretaries, chauffeurs, valets, maids, and traveling companions. But
our conscience smote us when we looked at that tonneau, the size
of a small boat, empty, save for our luggage, which, let me add with
infinite pride and satisfaction, was not on the running-boards, nor
strapped to the back. From the exterior appearance of the car we
might have been shopping on Fifth Avenue.
We extended an invitation to two friends to accompany us, which
was accepted by return mail, with the remark, “Go!—of course, we
will go! Never give such an invitation to this family unless you are in
earnest.” And so our genial friends joined us, and we picked them up
at the Seymour Hotel in New York City, at three o’clock, Saturday,
July 19th, and started for the Forty-second-Street ferry in a pouring
rain, as jolly and happy a quartette as the weather would permit. Our
guests were a retired physician, whom we shall speak of as the
Doctor, and his charming, somewhat younger wife, who, although
possessing the perfectly good name of Helen, was promptly dubbed
“Toodles” for no reason in the world. These dear people were of the
much-traveled type, who took everything in perfect good-nature and
were never at all fussy nor disturbed by late hours, delays, bad
weather, nor any of the usual fate of motorists, and they both added
to the pleasure of the trip as far as they accompanied us.
It had rained steadily for three days before we started and it
poured torrents for three days after; but that was to be expected, and
the New Jersey and Pennsylvania roads were none the worse, and
the freedom from dust was a boon. We chose for the slogan of our
trip, “It might have been worse.” The Doctor had an endless fund of
good stories, of two classes, “table and stable stories,” and I regret
to say that this apt slogan was taken from one of his choicest stable
stories, and quite unfit for publication. However, it did fit our party in
its optimism and cheery atmosphere.
With a last look at the wonderful sky-line of the city, and the hum
and whirl of the great throbbing metropolis, lessening in the swirl of
the Hudson River, we really were started; with our faces turned to
the setting sun, and the vast, wonderful West before us.
 II

NEW YORK TO PITTSBURGH

One of the all-absorbing pleasures in contemplating a long trip is

to map out your route. You hear how all your friends have gone, or
their friends, then you load up with maps and folders, especially
those published by all the auto firms and tire companies, you pore
over the Blue Book of the current year, and generally end by going
the way you want to go, through the cities where you have friends or
special interests. This is exactly what we did. As the trip was to be
taken in mid-summer, we concluded to take a northern route from
Chicago, via Milwaukee, St. Paul, Fargo, Billings, Yellowstone Park,
Salt Lake City, Ogden, Reno, Sacramento, to San Francisco (see
map), and, strange to relate, we followed out the tour as we had
planned it. With the exception of a few hot days in the larger cities
and on the plains, and, of course, in the desert, we justified our
decision.
As I have stated, we drove 4154 miles, through sixteen states
and the Yellowstone Park, in thirty-three running days, and the trip
took just seven weeks to the day, including seventeen days spent in
various cities, where we rested and enjoyed the sights. As time was
of no special object, and we were not attempting to break any
records, we felt free to start and stop when we felt inclined to do so;
on only two mornings did we start before nine-thirty, and seldom
drove later than seven in the evening. In so doing, we made a
pleasure of the trip and not a duty, and avoided any unusual fatigue.
The first evening we reached Easton, Pennsylvania. We were
glad to get into the comfortable Huntington Hotel out of the wet, and
enjoyed a good dinner and a night’s rest. We followed the Lincoln
Highway to Pittsburgh, and have only praise to offer for the condition
of the road and the beauty of the small towns through which we
went. Of all the states that we crossed, Pennsylvania stands out par
excellence in good roads, clean, attractive towns, beautiful farming
country and fruit belts, and well-built, up-to-date farm buildings. In
other states we found many such farms, but in Pennsylvania it was
exceptional to find a poor, tumble-down farmhouse or barn. The
whole state had an air of thrift and prosperity, and every little home
was surrounded by fine trees, flowers, and a well-kept vegetable
garden.
The worst bugbear of the motorist are the detours. Just why the
road commissioners choose the height of the motoring season to
tear up the main highways and work the roads has always been a
mystery to me, and I have never heard any logical solution of it. We
were often told that no work to speak of had been done on the state
roads through the country during the war, and in many places the
heavy army trucks had cut up the good roads until the ruts left turtle-
backed ridges in the center, not at all pleasant to bob along on. But,
in view of what we encountered later in our trip, I look back on the
Pennsylvania roads as one of the high spots and pleasures, never to
be undervalued.
From Easton we drove in the rain to Harrisburg. The scenery
was beautiful. The Blue Ridge and the Alleghany Mountains loomed
up in the haze like great cathedrals; but as long as the road was
wide and comparatively smooth we enjoyed the ups and downs. Our
engine told us that we were gradually ascending; the mist would be
wafted off by a mountain breeze, and then a gorgeous panorama
stretched before us as far as the eye could see.
We found Harrisburg a busy, thriving city, with well-paved
streets, attractive homes, and many fine buildings. The leading hotel,
the Penn Harris, was turning away guests; so we were made very
comfortable at the Senate. Here the café was miserable, but we
went to the restaurant of the Penn Harris and had an excellent
dinner at moderate prices. We have found that at the largest, best
hotels the food was better cooked and much cheaper than at the
smaller ones. Usually we had excellent club breakfasts from forty