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 review of the financial crisis of 2008. 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. 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, Dark Pools, high Frequency Trading, and Regulation 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 B. The moral hazard created by executive stock options. C. The events of the 1990s. D. 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 B. Securitization Selling loans to an issuer who issues Collateralized Deb Obligations (CDOs). 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 E. Interest Rates Rise The Fed raises rates 2004–6 to prevent inflation triggering massive defaults on subprime loans. F. The Effect on the CDO Market and CDO Owners G. Federal Government Actions in 2008 H. Why the crisis was an ethical issue of corporate governance. I. Bailouts as Moral Hazards K. The Dodd-Frank Act V. INTEREST 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. 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 NASDAQ Stock Exchange. 7. Describe the process that occurs when an investor places an order with a broker to buy or sell stocks under the market maker/specialist system. 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. 8. What is meant by transparency in the context of trading stocks on an exchange? Answer: Exchange based trades are transparent in the sense that most of the information about the transaction is immediately publicly available as soon as orders are placed. I.e., when a buy or sell order is placed, the size of the order and the identity of the person or organization behind it become available to all other traders. 9. What problems does an institutional investor face when it places a very large buy or sell order for a block of stock through an exchange. Answer: The first and simplest problem is cost. Commissions and fees are generally higher in exchange based trading than off exchange trading. The second problem is related to transparency which is a detriment to a trader in this situation. Very large orders may take more than a day to execute. But as soon as the order is posted it is seen by the entire market, and everyone knows, in the case of a sell order, that a new supply stock has just become available and who is offering it for sale. Effectively the order creates an increase in supply, i.e., a shift of the supply curve to the right. That shift moves the curve’s intersection with the down sloping demand curve to the right and a lower price. That means, to sell the entire block of stock, the institution, must accept less than the initial market price for at least some of the shares sold. Similarly, a large buy order shifts the demand curve to the right to a higher intersection with the up sloping supply curve, so the buyer will pay more than the initial market price for at least some of its order. In other words, the transparency of exchange based trading moves the market against the large trader. 10. Describe the nature and purpose of dark pools. Who runs dark pools for whose benefit? Answer: A dark pool is a market that provides many of the services of exchanges but is less heavily regulated and is not transparent. That means large investors can place orders without the rest of the market becoming aware of their intentions and therefore without moving the market against themselves. Dark pools were originally created to help institutional investors trade large blocks of stock without suffering adverse price effects due to their own trades. (See question 9 above.) Dark pools are typically run by large Wall Street banks for the benefit of their institutional clients. 11. How does High Frequency Trading (HFT) work? How do regulators feel about HFT? Answer: High Frequency Traders use computer and data communications technology to place buy and sell orders for stocks as little as a fraction of a second before the beginning of market movements predicated on new information (news) or lightning fast analysis of market activity. In this way they jump in and out of the market thousands of times a day, generally making a small profit on each of thousands of trades. They have been accused of manipulating markets and taking advantage of other investors by obtaining priority access to information unfairly especially within certain dark pools. The SEC and the New York the SEC and the New York Attorney General’s office have investigated pool/HFT activity alleging that pools have given preference to HFTs, failed to disclose how dark pools operate to all who trade on them, and that some illegal market manipulation has occurred. 12. 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. 13. 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 parties to the trades who don't have access to the inside information. 14. Explain the following terms: privately held company, publicly traded company, listed company, OTCBB, NASDAQ, BATS, 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 major exchange located in New York City that competes with the NYSE and BATS BATS – The third major exchange located in Kansas. The other two are in New York City. 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 prior to an IPO. Red Herring - a preliminary prospectus in the review process by the SEC. So-called because of a red stamp indicating its status. 15. 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. 16. 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 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. 17. 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. 18. 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. 19. 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. 20. 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. 21. What bank problems does securitization solve? Answer: Securitization gets the bank its cash back immediately upon selling the loan which it can then use to make another loan earning additional fees for its efforts. 22. 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 isn’t true when there are many subprime loans in the pool of loans. 23. 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. 24. 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 beginning in 2004 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. 25. 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. 26. Discuss the similarities and differences between supply and demand for a good (product or service) and supply and demand in a money (debt) market. 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). 27. 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. 28. 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. 29. 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, 30. 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. 31. 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? 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. 32. 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. 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. 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 ratio is the ratio of the ratio of the current price to earnings per share (EPS). P/E = Price / EPS = $42.09 / $2.48 = 16.97 The small difference between that and the listing of 16.95 is due to rounding in the EPS figure. Executive Stock Options – Example 5-1 (page 196) 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? Solution: 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 198) 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 215) 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%. 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 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. 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 216 14. Economists have forecast the following yearly inflation rates over the next 10 years: Calculate the inflation components of interest rates on new bonds issued today with terms varying from one (1) to ten (10) years. Solution: 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: (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: Next, create a table with a column for each of the elements of interest rate model, fill in each column, and add across. b., c. 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. 17. Assume that interest rates on federal government bonds are as follows: 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%. [(8 x 4.0%) + (2 x 6.5%)]/10 = 4.5% Solution Manual for Practical Financial Management William R. Lasher 9781305637542
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