Chapter 2, Page 1 of 5

Chapter 2

Questions

1. Opportunity cost - The difference between the value of one action and the value of the best alternative action.
Principal-Agent relationship - A situation in which one participant, the agent, makes decisions that affect another
participant, the principal.
Moral hazard - A situation in which an agent can take unseen actions for personal benefit even though such actions
are costly to the principal.
Zero-sum game - A situation in which one player can gain only at the expense of another player.
Sunk Cost - A cost that has already been incurred and cannot be altered by subsequent decisions.
Hubris - An arrogance due to excessive pride and an insolence toward others.
Adverse Selection - When offering something to the market seems to indicate something negative about what is
being offered.

2. One principal-agent relationship in which a moral hazard could arise is the relationship between an owner and a
manager. A manager could take a nap while on the job, or use the firms car for personal business. These actions
benefit the manager at the expense of the owner without the owner ever knowing.

3. Option - The right, without any obligation, to do something.
Call option - The right to buy something at a given price during the life of the option.
Put option - The right to sell something at a given price during the life of the option.

4. A portfolio is a group of investments, as opposed to a single investment. Diversification is the act of spreading your
wealth across multiple investments instead of concentrating them in a single investment. This is beneficial because
all your wealth won=t be lost unless all of the investments fail. Diversifying lowers risk by limiting the amount of the
investment lost if one or more fail.

5. a) A spot market is a market in which assets are bought and sold for immediate delivery. A futures market is a
market in which standardized forward contracts are traded.
b) A call option is the right to buy, while a put option is the right to sell something at a given price during the life
of the option.
c) An option contract is the right, without any obligation, to buy or sell something. A futures contract is a
standardized forward contract that is traded in a futures market.
d) A broker helps investors buy or sell securities, charging a sales commission but without taking ownership of the
shares. A dealer actually takes ownership of the shares before selling them to someone else.
e) An investment banker specializes in marketing new securities in the primary market. A financial intermediary is
an institution that offers financing to corporations.
f) A primary market is a market in which firms sell newly created securities to raise capital. A secondary market is
a market in which previously created securities are traded.
g) An initial public offering (IPO) refers to the first time a firm issues shares to sell to the public. A seasoned
equity offering refers to any offering of additional new shares for a firm that already has shares outstanding.
h) A forward contract is a contract to exchange an asset for cash at a specific future date. A futures contract is a
standardized forward contract that is traded in a futures market.
i) Stock is a share of equity issued by a corporation to raise capital. A bond is a long-term debt security issued by
a corporation to raise capital (borrow money).

6. Limited liability is a legal concept within bankruptcy that limits an investor=s possible loss to what has already been
invested.
Limited liability creates an option for a borrower because the borrower has the option to default or not fully
repay a debt.

7. Prices of assets in an efficient capital market adjust quickly to new information about the assets being traded.
Arbitrage is the act of buying and selling an asset simultaneously, where the sale price is greater than the
purchase price, so that the difference provides a risk-free profit.

Chapter 2, Page 2 of 5

8. Compound interest is when you earn additional interest on interest previously earned.

9. Longer lived securities are riskier. Much of this risk depends on inflation expectations, which are an important
determinant of interest rates. Therefore, if all else is equal, the Principle of Risk-Return Trade-Off implies that
investors will require a higher interest rate (return) to bear the extra risk. This is the basis for the idea that the term
structure should be upward sloping.
If investors believe that long-term interest rates are going to be lower next year, they will want to make
long-term investments today. If investors don=t have the funds to make the investment today, they will borrow short-
term and repay the money in the future with income from the investments. This decreases the supply of short-term
funds and, at the same time, increases the supply of long-term funds. The shift in these supplies raises the short-
term rate and lowers the long-term rate. This can result in a downward-sloping term structure.

10. Ethics consists of standards of conduct or moral judgment. Following all applicable rules and regulations does not
necessarily make one an ethical person. No set of rules and regulations can account for everything that can and will
happen. A code of ethics can reduce unethical behavior by providing a set of guidelines that can be applied generally
to situations that arise.

11. Behaving ethically brings about some direct benefits. Some of these benefits are outlined below.
i. Ethical behavior avoids fines and legal expenses.
ii. It builds customer loyalty and sales.
iii. It helps attract and keep high-quality employees and managers.
iv. It builds public confidence and adds to the economic development of the communities in which
the firm operates.
v. A good reputation enhances relations with the firm=s investors.

12. Incremental benefits are the differences in results when choosing among alternatives. Financial decisions are based
on incremental benefits because the comparison shows which alternative is superior.
Sunk costs do not affect the incremental benefit from a decision.

13. The major distinction between debt and equity is that debt is what a firm owes whereas equity is ownership in a
firm.
This distinction is important because the owners will determine how a firm is run, and will make decisions
that impact the debtholders.

Challenging Questions

14. Mary is the CEO of Ex-Why-Zee Corporation. J ohn is considering buying shares of Ex-Why-Zee and hears Mary
say the firm is doing well. J ohn realizes that there is asymmetric information in this situation. Mary has
information J ohn does not have. John, wisely, does his own independent research about how Ex-Why-Zee is doing.

15. J oan owns 500 shares of common stock in a private business and wants to sell the shares to J ane for $30,000. J oan
says the shares are a great investment and the present value of the money she thinks she will get during the next
five years is at least $30,000. J oan claims she wants the money now to remodel her house. J ane realizes there is an
adverse selection problem in this situation. Maybe what J oan says is true, but J ane wonders why J oan doesnt
borrow the money to remodel her house and pay the loan off with money from the private business. J oans desire to
sell her shares seems to indicate that J oan thinks they are not worth what she can sell them for. Of course, it is also
possible J oan has a thing against borrowing money and this would be a fabulous investment for J ane. However,
J oans offer implies a negative implication about the value of the shares.

16. The Principle of Two-Sided Transactions is important to financial decision making because when things are
complex, one can overlook the other sides viewpoint. The Principle of Self-Interested Behavior states that we act in
our own best interest. But so are those on the other side of the transaction. If you ignore their viewpoint, the other
side might gain an advantage in negotiating a contractto your disadvantage.

Chapter 2, Page 3 of 5

17. The chairman, assuming that he is concerned with his daughter=s well being, sold the shares in her best interest.
Perhaps the daughter wanted to spend some money, but thats a lot to spend. More likely this signal tells us that the
executives exaggerated the recent success of the firm. And even if business was jumping, business may be jumping
even higher in another firm. Therefore, it seems likely the chairman decided to invest the money in a better asset for
his daughter.

18. According to the Signaling Principle, an action we observe is the optimal action of a self-interested player, given a
particular information set. If a second player expects to face the same (or nearly the same) information set but does
not know exactly what is in the information set and it is costly (or impossible) to determine the information with
accuracy, the second player can infer that the action taken by the first player will also be in the second player's best
interest. As a result, we have the Behavioral Principlewhen all else fails, look at what others are doing for
guidance.

19. Two appropriate applications of the Behavioral Principle are (1) the case where there is a limit to our
understandingfor example, trying to choose an optimal capital structure for your firm when there is no clear-cut
financial theory upon which to base your choice; and (2) the case where its use is more cost-effective than obtaining
sufficient information to answer the question using the most accurate methodfor example, valuing certain assets
according to the prices of similar assets, rather than undertaking the extensive information gathering and estimation
needed to make a more accurate valuation. Two inappropriate applications are (1) "blind imitation" that involves
following the actions of other firms without considering how similar their situation is to yoursfor example,
matching your competitor's dividend policy when your expected future earnings are significantly different; and (2)
"blind imitation" that involves following the actions of the majority even though a little effort will reveal a better
course of action.

20. According to the Principle of Self-Interested Behavior, each party to a financial transaction will choose the course of
action that is most advantageous to that party, given the information they possess. A particular piece of information
may result in a particular action when the decision-maker acts in his own self-interest. In that case, we have the
signaling principle: observing the decision-maker's action may allow us to deduce the information that is known to
the decision-maker.

21. Silicon Inc. just spent $1 billion developing a new microchip that will change the way computing is done in a
lucrative industry. Silicon Inc. does not want a competitor to use the technology developed at Silicon Inc. to
compete with them. Therefore, Silicon Inc. applies for a patent to avoid providing such free-rider opportunities.

22. Prices adjust to offset imbalances between buy and sell orders. In this case, the buy orders outnumber the sell orders
and the price of the stock will rise until equilibrium is reached.

23. The market prices of common stocks of competitors are likely to fall after this announcement. Competition from a
successful new product line from this corporation would result in lower profit margins, development expenses, and
smaller future profits for competitors to remain competitive.

24. The Principle of Self-Interested Behavior implies that investors will make financial transactions in their own best
interest. The Principle of Two-Sided Transactions implies that for every share of stock that is sold by one investor,
there must be another (self-interested) investor who is willing to buy a share of stock and people buy or sell until the
market price reaches what they think is the correct value of each share. Together these two principles suggest that
when new information becomes available, investors will act in their own interest, buying or selling stock until the
market price adjusts to the new information. This is consistent with the Principle of Capital Market Efficiency. In
essence, each party (side) to a transaction applies the Principle of Self-Interested Behavior, thus enforcing the
Principle of Capital Market Efficiency.

25. The exact opportunity cost cannot be measured when a person switches from a job with sales commissions to a job
with a fixed salary. The opportunity cost could be estimated from past paychecks or projections of future sales, but
it cannot be known with certainty.
No. Uncertainty about the future prevents most opportunity costs from being measured exactly.


Chapter 2, Page 4 of 5

26. Capital markets are relevant to the performance of managers in any industry because managers may need access to
capital for expansion or raw materials. The cost of raising funds for expansion or raw materials will affect the
profits of the firm. A manager must take this into account when making decisions. A manager will also want to
watch the capital markets for signals from competitors, suppliers, and customers.

27. The announcement conveyed the signals that the decisions, plans, and actions of the CEO and chairman were
reasons for the firms poor performance and that a new CEO and chairman could be found who could significantly
improve the firms performance.

28. The information about IBMs sales, profits, and production contained implications about total market demand and
the success or failure of particular products. Such information in turn can imply changes in the prospective sales
and profits of competitor firms.


Problem Set A

A1. a. FV =PV(1 +r)
n

FV =$2,000(1 +0.20)
1
FV =$2,400
FV =$2,000(1 +0.20)
2
FV =$2,880
b. PV =FV / (1 +r)
n

PV =$2,000 / (1 +0.20)
1
PV =$1,666.67
PV =$2,000 / (1 +0.20)
2
PV =$1,388.89

A2. a. FV =PV(1 +r)
n

FV =$1,000(1 +0.10)
1
FV =$1,100
b. FV =$1,000(1 +0.10)
5
FV =$1,610.51
c. FV =$1,000(1 +0.06)
1
FV =$1,060
$1,100 - $1,060 =$40 less
FV =$1,000(1 +0.06)
5
FV =$1,338.23
$1,610.51 - $1,338.23 =$272.28 less

A3. PV =FV / (1 +r)
n

PV =$10,000 / (1 +0.12)
7
PV =$4,523.49

Problem Set B

B1. PV =FV / (1 +r)
n

PV =$15,000 / (1 +0.10)
11
PV =$5257.41

B2. FV =PV(1 +r)
n

FV =$30,000(1 +0.10)
3
FV =$39,930

B3. a. FV =PV(1 +r)
n

FV =$10,000(1 +0.10)
1
FV =$11,000
PV =FV / (1 +r)
n

PV =$11,000 / (1 +0.10)
1
PV =$10,000
b. FV =PV(1 +r)
n

FV =$10,000(1 +0.20)
1
FV =$12,000
PV =FV / (1 +r)
n

PV =$12,000 / (1 +0.10)
1
PV =$10,909.09
c. FV =PV(1 +r)
n

FV =$10,000(1 +0.10)
1
FV =$11,000
PV =FV / (1 +r)
n

PV =$11,000 / (1 +0.20)
1
PV =$9166.67

Chapter 2, Page 5 of 5

B4. PV =FV / (1 +r)
n

PV =$2,500 / (1 +0.10)
4
+$2,500 / (1 +0.10)
5

PV =$1,707.53 +$1,552.30 PV =$3,259.84

B5. a. Gain =$30,000 - $20,000 =$10,000 =exercise value
Yes. Use the call option.
Profit =$10,000 - $1,000 =$9,000
Return =($9,000 / $1,000) x 100% =900%
b. Gain =$15,000 - $20,000 =-$5,000, so exercise value =0
No. Do not use the call option.

B6. Sell it as is. If you put in another $80,000 adding on to it, you can only sell it for $220,000, which is less than $160,000
+$80,000 =$240,000 you would have in it after adding on to it.

Problem Set C

C1. a. Return(Stock) =($24 - $20) / $20 x 100% =20%
The call option is worth $24 - $20 =$4
Return(Call) =($4 - $2) / $2 x 100% =100%
The put option is worth $0
Return(Put) =($0 - $1) / $1 x 100% =-100%
b. Return(Stock) =($17- $20) / $20 x 100% =-15%
The call option is worth $0
Return(Call) =($0 -$2) / $2 x 100% =-100%
The put option is worth $20 - $17 =$3
Return(Put) =($3 - $1) / $1 x 100% =200%