For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is semistrong form but not strong form efficient, and (4) the market is strong form efficient. a. The stock price has risen steadily each day for the past 30 days. b. The financial statements for a company were released three days ago, and you believe you’ve uncovered some anomalies in the company’s inventory and cost control reporting techniques that are causing the firm’s true liquidity strength to be understated. c. You observe that the senior management of a company has been buying a lot of the company’s stock on the open market over the past week. Use the following information for the next two questions: Technical analysis is a controversial investment practice. Technical analysis covers a wide array of techniques, which are all used in an attempt to predict the direction of a particular stock or the market. Technical analysts look at two major types of information: Historical stock prices and investor sentiment. A technical analyst would argue these two information sets provide information about the future direction of a particular stock or the market as a whole.
> Two years ago, the Lake Minerals and Small Town Furniture stock prices were the same. The average annual return for both stocks over the past two years was 10 percent. Lake Minerals’ stock price increased 10 percent each year. Small Town Furniture’s stoc
> Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier divisions or the more conservat
> There are two stock markets, each driven by the same common force, F, with an expected value of zero and standard deviation of 10 percent. There are many securities in each market; thus, you can invest in as many stocks as you wish. Due to restrictions,
> You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.65 and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio?
> Consider the following information: a. What is the expected return on an equally weighted portfolio of these three stocks? b. What is the variance of a portfolio invested 20 percent each in A and B, and 60 percent in C? State of Rate of Return if S
> Consider the following quotation from a leading investment manager: “The shares of Southern Co. have traded close to $12 for most of the past three years. Since Southern’s stock has demonstrated very little price movement, the stock has a low beta. Texas
> Refer to Table 10.1 in the text and look at the period from 1973 through 1978. a. Calculate the arithmetic average returns for large-company stocks and T-bills over this period. b. Calculate the standard deviation of the returns for large-company sto
> Suppose stock returns can be explained by a two-factor model. The firm-specific risks for all stocks are independent. The following table shows the information for two diversified portfolios: If the risk-free rate is 4 percent, what are the risk premiu
> Two years ago, General Materials’ and Standard Fixtures’ stock prices were the same. During the first year, General Materials’ stock price increased by 10 percent while Standard Fixtures’ stock price decreased by 10 percent. During the second year, Gener
> Fama’s Llamas has a weighted average cost of capital of 9.8 percent. The company’s cost of equity is 13 percent, and its cost of debt is 6.5 percent. The tax rate is 35 percent. What is Fama’s debt–equity ratio?
> Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all-equity financed companies. Dow and Superior are looking at identical projects.
> You are forming an equally weighted portfolio of stocks. Many stocks have the same beta of .84 for Factor 1 and the same beta of 1.69 for Factor 2. All stocks also have the same expected return of 11 percent. Assume a two-factor model describes the retur
> A portfolio is invested 10 percent in Stock G, 65 percent in Stock J, and 25 percent in Stock K. The expected returns on these stocks are 9 percent, 11 percent, and 14 percent, respectively. What is the portfolio’s expected return? How do you interpret y
> Briefly explain why the covariance of a security with the rest of a well-diversified portfolio is a more appropriate measure of the risk of the security than the security’s variance.
> Based on the following information, calculate the expected return and standard deviation for the two stocks: State of Rate of Return if State Occurs Probability of State of Economy Economy Stock A Stock B Recession 20 .06 - 20 Normal 55 .07 .13 Boom
> Using the following returns, calculate the average returns, the variances, and the standard deviations for X and Y: Year Y 8% 12% 2 21 27 3 -27 -32 4 18 5 18 24
> Suppose you bought a 6 percent coupon bond one year ago for $1,040. The bond sells for $1,063 today. a. Assuming a $1,000 face value, what was your total dollar return on this investment over the past year? b. What was your total nominal rate of return o
> A study analyzed the behavior of the stock prices of firms that had lost antitrust cases. Included in the diagram are all firms that lost the initial court decision, even if the decision was later overturned on appeal. The event at Time 0 is the initial,
> Explain why a characteristic of an efficient market is that investments in that market have zero NPVs.
> For the firm in the previous problem, suppose the book value of the debt issue is $70 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity; the book value of this issue is $100 million
> What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What are the specific pieces of information needed to use this method? Are all of these variables observable, or do they need to be estim
> Suppose stock returns can be explained by the following three factor model: R i = R F + β 1 F 1 + β 2 F 2 β 3 F 3 Assume there is no firm-specific risk. The information for each stock is presented here: The risk pre
> You own stock in the Lewis-Striden Drug Company. Suppose you had expected the following events to occur last month: a. The government would announce that real GNP had grown 1.2 percent during the previous quarter. The returns of Lewis-Striden are positiv
> You have $10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 14 percent and Stock Y with an expected return of 9 percent. If your goal is to create a portfolio with an expected return of 12.9 percent, how much mone
> Assume Stocks A and B have the following characteristics: The covariance between the returns on the two stocks is .001. a. Suppose an investor holds a portfolio consisting of only Stock A and Stock B. Find the portfolio weights, X A and X B, such that
> What factors determine the beta of a stock? Define and describe each.
> The historical asset class returns presented in the chapter are not adjusted for inflation. What would happen to the estimated risk premium if we did account for inflation? The returns are also not adjusted for taxes. What would happen to the returns if
> There are two stocks in the market, Stock A and Stock B . The price of Stock A today is $75. The price of Stock A next year will be $64 if the economy is in a recession, $87 if the economy is normal, and $97 if the economy is expanding. The probabilities
> Suppose you observe the following situation: a. Calculate the expected return on each stock. b. Assuming the capital asset pricing model holds and Stock A’s beta is greater than Stock B’s beta by .25, what is the exp
> There are three securities in the market. The following chart shows their possible payoffs: a. What are the expected return and standard deviation of each security? b. What are the covariances and correlations between the pairs of securities? c. What a
> Suppose you observe the following situation: Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate? Security Beta Expected Return Pete Corp. 1.35 12.28% Repete Co. 80
> Consider the following information about Stocks I and II: The market risk premium is 7.5 percent, and the risk-free rate is 4 percent. Which stock has the most systematic risk? Which one has the most unsystematic risk? Which stock is “
> Suppose the risk-free rate is 4.2 percent and the market portfolio has an expected return of 10.9 percent. The market portfolio has a variance of .0382. Portfolio Z has a correlation coefficient with the market of .28 and a variance of .3285. According t
> A portfolio that combines the risk-free asset and the market portfolio has an expected return of 7 percent and a standard deviation of 10 percent. The risk-free rate is 4 percent, and the expected return on the market portfolio is 12 percent. Assume the
> The market portfolio has an expected return of 12 percent and a standard deviation of 22 percent. The risk-free rate is 5 percent. a. What is the expected return on a well-diversified portfolio with a standard deviation of 9 percent? b. What is the stand
> Suppose a stock had an initial price of $75 per share, paid a dividend of $1.20 per share during the year, and had an ending share price of $86. Assuming the ending share price is $67. Compute the percentage total return. What was the dividend yield? Th
> The following figures present the results of four cumulative abnormal returns (CAR) studies. Indicate whether the results of each study support, reject, or are inconclusive about the semi-strong form of the efficient market hypothesis. In each figure, Ti
> Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be negative after the fact? Explain.
> Assume that the returns on individual securities are generated by the following two-factor model: R it = E ( R it ) + β ij F 1 t + β i 2 F 2 t Here: Rit is the return on Security i at Time t. F1t and F2tare market factors with zer
> Which of the following statements are true about the efficient market hypothesis? a. It implies perfect forecasting ability. b. It implies that prices reflect all available information. c. It implies an irrational market. d. It implies that prices do not
> Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which
> Suppose a factor model is appropriate to describe the returns on a stock. The current expected return on the stock is 10.5 percent. Information about those factors is presented in the following chart: a. What is the systematic risk of the stock return?
> David McClemore, the CFO of Ultra Bread, has decided to use an APT model to estimate the required return on the company’s stock. The risk factors he plans to use are the risk premium on the stock market, the inflation rate, and the price of wheat. Becaus
> You have been provided the following data about the securities of three firms, the market portfolio, and the risk-free asset: a. Fill in the missing values in the table. b. Is the stock of Firm A correctly priced according to the capital asset pricing
> Suppose the expected returns and standard deviations of Stocks A and B are E( R A ) = .09, E( RB ) = .15, αA = .36, and αB 5 .62. a. Calculate the expected return and standard deviation of a portfolio that is composed of 35 percent A and 65 percent B whe
> Suppose the returns on large-company stocks are normally distributed. Based on the historical record, use the NORMDIST function in Excel ® to determine the probability that in any given year you will lose money by investing in common stock.
> Prospectors, Inc., is a publicly traded gold prospecting company in Alaska. Although the firm’s searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors’ cumulative abn
> Security F has an expected return of 10 percent and a standard deviation of 43 percent per year. Security G has an expected return of 15 percent and a standard deviation of 62 percent per year. a. What is the expected return on a portfolio composed of 30
> Suppose Tom O’Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm’s cost of debt and cost of equity capital. a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It
> In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?
> Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent
> In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? If a firm issues equity to repurchase some of its debt, the price per share of the firm’s stock will rise because th
> Beginning with the cost of capital equation—that is: show that the cost of equity capital for a levered firm can be written as follows: В RWACC =B+SRs+ B+S R, = R, + (R, - R)
> Suppose a firm’s business operations mirror movements in the economy as a whole very closely—that is, the firm’s asset beta is 1.0. Use the result of previous problem to find the equity beta for this firm for debt–equity ratios of 0, 1, 5, and 20. What d
> Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, R f . Define βA as the firm’s asset beta—that is, the systematic risk of the firm’s assets. Define βS to be the beta of the firm’s equity. Use the capital asset pricin
> Assuming a world of corporate taxes only, show that the cost of equity, R S, is as given in the chapter by MM Proposition II with corporate taxes.
> In a world of corporate taxes only, show that the R WACC can be written as R WACC = R0 × [1 – tC ( B/V )].
> Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent. Williamson is subject to a corporate tax rate of 35 percent. a. What is Williamson’s cost of equity cap
> Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6 percent. Green is currently an all-equity firm worth $6.3 mil
> Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt–equity ratio is expected to rise from 35 percent to 50 percent. The firm currently has $3.6 million worth of debt outstandin
> The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Company’s 6 percent bonds is $1.4 million. Financial information for the two firms appears here. All
> An election is being held to fill three seats on the board of directors of a firm in which you hold stock. The company has 7,600 shares outstanding. If the election is conducted under cumulative voting and you own 300 shares, how many more shares must yo
> Acetate, Inc., has equity with a market value of $23 million and debt with a market value of $7 million. Treasury bills that mature in one year yield 5 percent per year, and the expected return on the market portfolio is 12 percent. The beta of Acetate’s
> Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an allequity firm, has 15,000 shares of stock outstanding, currently worth $30 per share. Beta Corporation uses leverage in its capital
> The Maxwell Company is financed entirely with equity. The company is considering a loan of $1.8 million. The loan will be repaid in equal installments over the next two years, and it has an interest rate of 8 percent. The company’s tax rate is 35 percent
> Cavo Corporation expects an EBIT of $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent. a. What is the current value of the company? b. Suppose the company can borrow at 10 percent. If the corporate tax ra
> Tool Manufacturing has an expected EBIT of $57,000 in perpetuity and a tax rate of 35 percent. The firm has $90,000 in outstanding debt at an interest rate of 8 percent, and its unlevered cost of capital is 15 percent. What is the value of the firm accor
> Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $29 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpe
> Sinking funds have both positive and negative characteristics for bondholders. Why?
> Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if B
> If interest rates fall, will the price of noncallable bonds move up higher than that of callable bonds? Why or why not?
> Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if B
> What are the main features of a corporate bond that would be listed in the indenture?
> Do you agree or disagree with the following statement: In an efficient market, callable and noncallable bonds will be priced in such a way that there will be no advantage or disadvantage to the call provision. Why?
> Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is currently 11 percent, and the tax rate is 35 percent. a. What is Shadow’s cost of equity? b. If the firm converts to 25 percent debt, what will its cost of equity be? c. If the firm
> Several publicly traded companies have issued more than one class of stock. Why might a company issue more than one class of stock?
> Weston Industries has a debt–equity ratio of 1.5. Its WACC is 11 percent, and its cost of debt is 7 percent. The corporate tax rate is 35 percent. a. What is Weston’s cost of equity capital? b. What is Weston’s unlevered cost of equity capital? c. What w
> The following Treasury bond quote appeared in The Wall Street Journal on May 11, 2004: Why would anyone buy this Treasury bond with a negative yield to maturity? How is this possible? 9.125 May 09 100.09375 100.12500 -2.15
> Consider the prices of the following three Treasury issues as of February 24, 2012: The bond in the middle is callable in February 2013. What is the implied value of the call feature? (there a way to combine the two noncallable issues to create an issu
> Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If the current market value of the equity is $37 million and there are no taxes, what is EBIT? Suppose the corporate tax rate is 35 percent. What is EBIT in this case? What is t
> Charles River Associates is considering whether to call either of the two perpetual bond issues the company currently has outstanding. If the bond is called, it will be refunded, that is, a new bond issue will be made with a lower coupon rate. The procee
> Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is held by one institution that is willing to sell it back to OPC fo
> Continental Airlines once filed for bankruptcy, at least in part, as a means of reducing labor costs. Whether this move was ethical or proper was hotly debated. Give both sides of the argument.
> Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent. The company also has a perpetual bond issue outstanding
> New equity issues are generally only a small portion of all new issues. At the same time, companies continue to issue new debt. Why do companies tend to issue little new equity but continue to issue new debt?
> When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions equals zero is: VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C ( B
> ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 8 perc
> An outstanding issue of Public Express Airlines debentures has a call provision attached. The total principal value of the bonds is $250 million, and the bonds have an annual coupon rate of 9 percent. The company is considering refunding the bond issue.
> Do you think preferred stock is more like debt or equity? Why?
> Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total ca
> As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this a proper use of the bankruptcy process?
> Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain
> Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 7 percent, payable annually. The one-year interest rate is 7 percent. Next year, there is a 35 percent probability that interest rates will increase to 9 per
> Bowdeen Manufacturing intends to issue callable, perpetual bonds with annual coupon payments. The bonds are callable at $1,175. One-year interest rates are 9 percent. There is a 60 percent probability that long-term interest rates one year from today wil
> What are the direct and indirect costs of bankruptcy? Briefly explain each.
> Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that
> Refer to the observed capital structures given in Table 17.3 of the text. What do you notice about the types of industries with respect to their average debt–equity ratios? Are certain types of industries more likely to be highly levera
> Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. Ignoring taxes, wha
> Is there an easily identifiable debt–equity ratio that will maximize the value of a firm? Why or why not?
> A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?
