Chapter 1: Q15I. (page 24)
We noted that oversight by large institutional investors or creditors is one mechanism to reduce agency problems. Why don’t individual investors in the firm have the same incentive to keep an eye on management?
No incentive to an individual investor as his payoff would be small.
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Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth \(30,000 and has cash on hand of \)20,000 contributed by Lanni’s owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction?
a. Lanni takes out a bank loan. It receives \(50,000 in cash and signs a note promising to pay back the loan over three years.
b. Lanni uses the cash from the bank plus \)20,000 of its own funds to finance the development of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the form of 5,000 shares of Microsoft stock.
d. Lanni sells the shares of stock for $25 per share and uses part of the proceeds to pay off the bank loan.
How do security dealers earn their profits?
Now visit the website of the NASD, www.finra.org. What is its mission? What information and advice does it offer to beginners?
Suppose that Intel currently is selling at \(40 per share. You buy 500 shares using \)15,000 of your own money, borrowing the remainder of the purchase price from your broker. The rate on the margin loan is 8%.
a. What is the percentage increase in the net worth of your brokerage account if the price of Intel immediately changes to (i) \(44; (ii) \)40; (iii) \(36? What is the relationship between your percentage return and the percentage change in the price of Intel?
b. If the maintenance margin is 25%, how low can Intel’s price fall before you get a margin call?
c. How would your answer to ( b ) change if you had financed the initial purchase with only \)10,000 of your own money?
d. What is the rate of return on your margined position (assuming again that you invest \(15,000 of your own money) if Intel is selling after one year at (i) \)44; (ii) \(40; (iii) \)36?
What is the relationship between your percentage return and the percentage change in the price of Intel? Assume that Intel pays no dividends.
e. Continue to assume that a year has passed. How low can Intel’s price fall before you get a margin call?
What is the difference between asset allocation and security selection?
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