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INSTRUCTOR'S MANUAL
AND
TEST BANK
INVESTMENTS: AN INTRODUCTION
Tenth Edition
Herbert B. Mayo
The College of New Jersey
CONTENTS
Part 1 The Investment Process and Financial Concepts
Chapter 1 An Introduction to Investments 1
Chapter 2 Securities Markets 5
Chapter 3 The Time Value of Money 22
Chapter 4 Financial Planning, Taxation, and
the Efficiencyof Financial Markets 40
Chapter 5 Risk and Portfolio Management 54
Part 2 Investment Companies
Chapter 6 Investment Companies: Mutual Funds 70
Chapter 7 Closed-end Investment Companies,
Real Estate Investment Trusts (REITs),
and Exchange-Traded Funds (ETFs) 80
Part 3 Investing in Common Stock
Chapter 8 Stock 93
Chapter 9 The Valuation of Common Stock 110
Chapter 10 Investment Returns and Aggregate
Measures of Stock Markets 128
Chapter 11 The Macroeconomic Environment
for Investment Decisions 148
Chapter 12 Behavioral Finance and Technical
Analysis 151
Part 4 Investing in Fixed Income Securities
Chapter 13 The Bond Market 154
Chapter 14 The Valuation of Fixed Income Securities 161
Chapter 15 Government Securities 193
Chapter 16 Convertible Bonds and Convertible
Preferred Stock 216
Part 5 Derivatives
Chapter 17 An Introduction to Options 238
Chapter 18 Option Valuation and Strategies 255
Chapter 19 Commodity and Financial Futures 275
Part 6 An Overview
Chapter 20 Investing and Portfolio Management
in an Efficient Market Context 287
Test Bank
PREFACE
The primary objective of Investments: An Introduction is to facilitate students' learning and remembering the importance of financial planning, risk and portfolio management, the mechanics of investing in financial assets, and analytical tools to value and select securities. Since the text is an introduction, the individual instructor may wish to omit specific topics and develop others at greater depth. The text is broad in scope. It includes the traditional investments and possible alternative investments such as real estate investment trusts that are often not covered in textbooks on investments. Since investing is a process designed to serve a purpose, the text also includes financial planning in addition to securities analysis and valuation.
This instructor's manual is designed to ease the burden of teaching. It consists of answers to the questions and problems in the text and a test bank of multiple choice questions, truefalse statements, and additional problems. The answers given to the questions in the text are meant to be guides and in some cases offer suggestions as to how the questions may be used in class.
FACTORS TO CONSIDER WHEN USING THIS TEXT
The individual instructor should consider several factors when using the text. First, the book is primarily designed for a junior level undergraduate course or the investment professional, especially individuals sitting for the CFP exam who need a basic review of the valuation tools covered in more advanced investment textbooks. Many of the students taking an initial investments course will be business oriented, so I have assumed that these students have had some course work in accounting and economics. However, I have also assumed this exposure is modest or the retention is low. This is a reasonable assumption since over three-fourths of the material learned in a course is forgotten within a year. Thus, material covered in prior courses is repeated (e.g., ratio analysis of financial statements), so it may be applied in this text. Other material (e.g., the composition of financial statements) is assumed knowledge and not repeated. Obviously, for students who have not had this background, knowledge of this material is important. The individual instructor, however, will have to determine if his or her own students lack the necessary background.
The numerical examples in the text are simple to facilitate following the calculations and increase the time spent on the concept being illustrated. While simple examples may not be realistic, I prefer to stress the concept being illustrated and not the calculations.
With the exception of the first and last chapters, each chapter has a set of questions most of which repeat the material in the text. The purpose of these questions is to review; they are not designed to probe or expand upon the text material.
Since some students learn concepts through solving numerical problems, simple problems have been included in the text and in this instructor's manual. They are similar to the numerical examples used in the text. The problems are primarily designed to illustrate concepts and not to test mathematical reasoning or capacity to handle complex problems. The instructor should caution the student to comprehend the concept and not to memorize the mechanics of the problem.
The text also includes brief cases, which are essentially problems in more realistic settings. Unlike the problems, the cases may have ambiguities. While the intent of the problems is to reinforce a particular analytical tool or concept, the cases also illustrate how answering the problems facilitates investing and selecting among competing alternatives.
In some of the cases there may be no correct answers (except to individual questions within the case), since the purpose is to generate discussion and reinforce what should be obvious: investing is not mechanical and at the moment a decision is made conflicting factors must be reconciled or ignored. Unfortunately only after the decision is made and time passes will the investor know if a correct (but not necessarily the best) decision was made. But that, of course, applies to many of life's decisions.
TEACHING GUIDES FOR THE CASES
It is my preference to have students lead problem and case class discussions. I select two students (with at least one week advance notice) to serve as leader or moderator and to perform the calculations and conduct the discussion. The use of handouts and/or visual aids is required, but I do not specify which or the general format, since that should vary with the specific problem or case.
It would be nice to assume that all students perform the assignments prior to class, but that rarely, if ever, happens. The presenters are usually well prepared. I do not grade the presentations, but over the semester the problems and the cases help identify the better students in the class.
LEARNING AIDS FOR THE STUDENT
The text includes pedagogical features designed to help the learning process. Each chapter begins with learning objectives that stress points that will be developed in the chapter. Each chapter has terms in bold print and defined in the margin. The chapters have questions and problems that are similar to the illustrations in the body of the text.
In addition to learning objectives and margin definitions, short specific topics, referred to as "Point of Interest," are included and separated from the body of the text. Often these are an interesting point that may amplify the text. In other cases they add a sidelight to the text coverage or provide websites and sources of additional information. While the instructor may easily omit these points, they may be used to generate interest or expand upon the text material.
POSSIBLE ORGANIZATIONS OF INVESTMENT COURSES
The text has twenty chapters, but I do not anticipate that instructors will complete the entire book in a semester course. Many of the chapters are selfcontained units, so individual chapters may be omitted without loss of continuity. There are, however, exceptions to this generality. For example, the valuation of bonds (Chapter 14) assumes that the student knows time value of money (Chapter 3).
The text initially covers the process of investing and fundamental financial concepts (Chapters 25 in Part One). These include the role of brokers and financial advisors, initial public offerings, secondary markets, taxation, and risk measurement. These chapters are not easily omitted, for they are the fundamental background in which investment decisions are made.
Part Two, Chapters 6 and 7, is devoted to investment companies. Reviewers express no consensus where this material should be placed in an investment textbook. Since the only financial assets some individuals will acquire are shares in investment companies, there may be a strong reason to cover them before individual securities. Other instructors, however, may prefer to defer or omit the coverage of investment companies.
The bread and butter of investing in financial assets is the analysis and selection of common stock (Part Three) and investing in fixed income securities (Part Four). Most of this material should be covered, but numerous topics such as technical analysis for stocks, duration for bonds, government securities such as municipal bonds, or convertibles may be omitted.
Part Five is devoted to derivatives (options and futures). My students become fascinated with puts and calls, so I tend to spend a disproportionate time on them. I also spend the last class on Chapter 20 to remind students that investing is not an end but a means to achieve financial objectives and that few, if any of them, will consistently outperform the market on a risk-adjusted basis.
COURSE THEMES
Most of the chapters deal with a particular facet of investments. Some concepts, however, are more important than others. It may not be obvious to the student which concepts (e.g., valuation, efficient markets, and the risk/return trade off) are the most important. In class I use these important concepts as themes and frequently bring them into the discussions. In the first class I introduce choosing among alternative investments, efficient markets, risk versus return, and valuation. While no one has read any material before the first class, mentioning these concepts gives the student a preview of material that will be developed. Throughout the semester, I refer back to these concepts so that they are frequently being reviewed.
TEST QUESTIONS
This manual includes a test bank of multiple choice questions, true-false statements, and additional problems. The multiple choice or true-false statements may be easily converted into short discussion questions. Short essay questions permit the student the opportunity to overcome any ambiguity in the question, and they force the student to write.
THE INVESTMENT ASSIGNMENT
The investment assignment is a paper portfolio that is carried through the semester. (There are two versions of this assignment.) This paper portfolio is not a stock market game in which students buy and sell securities. While stock market games may have their place, I believe they encourage excessive risk taking and excessive trading, which are not lessons I believe a novice investor needs. The paper portfolios require the student to track the stocks throughout the semester. In the first version, the student invests $10,000 in each of ten stocks. (Using $10,000 facilitates comparisons and avoids the problem of different weights for different stocks.) In the second version of the investment assignment, I have selected five companies and ask the student to select five and then compare their stocks to mine as the semester progresses.
During any three to fourmonth time semester, something of note usually occurs in the financial markets. Interest rates may rise or fall or the stock market may experience a large price change. By requiring the student to watch the same securities throughout the semester, they may see the impact the changes have on specific stocks.
FINANCIAL CALCULATORS AND COMPUTERS
Cengage has provided an Investment Analysis Calculator, which is a menu-driven set of programs designed to do many of the calculations employed in investments. While it may be found at the publisher’s home page, an easy and efficient means to access it is to go to Google and search for Investment Analysis Calculator. Time value of money, bond valuation, stock valuation, betas, analysis of financial statements, and rates of return are all covered by the programs. The Investment Analysis Calculator’s coverage is not exhaustive of the problems in the text. For example, problems on taxes are excluded.
An alternative to the Investment Analysis Calculator is to use a computer program such as Excel. Financial calculators also perform many of the functions used in investments. While Excel or the Investment Analysis Calculator, may ease a students' work, they can also create a problem. Although the purpose of computer programs and financial calculators is to facilitate solving the problems, they should not be a substitute for learning and understanding the mechanics of the problems.
For example, computation of a bond's price is easy. All the student does is enter the bond's coupon, the amount of the principal, the term of the bond, and the current rate of interest, and almost immediately the price of the bond appears. However, I believe that it is important for the student to understand how that value is determined. I want students to know the mechanics, and point out that on tests they will only have access to interest tables and formulas (which I provide), and electronic calculators (which they provide).
Computer programs and financial calculators are particularly useful for problems that require a large number of simple and repetitive calculations (e.g., the price of a bond at various interest rates) or when interest tables can provide only imprecise results (e.g., yield to maturity). The software also permits using a rate of interest such as 5.6 percent instead of 5 percent and can be useful for calculating rates of return when the annual cash flows are not equal. Assigning these types of problems may help students realize the usefulness of the programs and spreadsheets.
INTERNET SOURCES
The Internet has become for many people their primary source of information (or at least their initial source). For this reason, I have not included selected readings at the end of each chapter. Some references do appear in footnotes, but I assume that students prefer to use the Internet. Throughout the text, web addresses are provided. Unfortunately, some of these addresses may change. Even if the addresses do not change, the content of the sites may, so some flexibility is desirable when using these sources. I also encourage students to perform their own searches, since they may find sites with more or better information to meet their specific needs.
WHY DID I WRITE THIS TEXT?
A primary motivation for writing this text is that many investment textbooks have become increasingly theoretical and are beyond the grasp of many students. I believe there is a need for a comprehensive text that includes institutional and descriptive material with some exposure to the theory and valuation of securities.