Dr. P.V. Viswanath

 

pviswanath@pace.edu

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Spring 2011

 
   
 

Midterm Practice 1

Notes:

  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  • You must explain all your answers.
  • Do any 7 of questions 2-10.
  • Question 11 is a take-home question; you must turn it in by midnight tomorrow night.

1. Answer any four questions from those below:

  1. Explain how the financial system facilitates the sharing and transfer of risk. Provide three different examples.
  2. What is adverse selection? Give an example of adverse selection in the context of a corporation.
  3. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?
  4. How is the role of the stock market in stock value maximization?
  5. Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate?
  6. What are the determinants of expected rates of return on assets in an economy?

2. Are there any disadvantages to requiring by law that a certain proportion of all directors be independent, i.e. that they not have any direct connection with the firm's operations?

3. Problem 25, page 48, Chapter 2.

4. Problem 16, page 46, Chapter 2.

5. Problem 17, page 76, Chapter 3.

6. Problem 13, page 75, Chapter 3.

7. Problem 45, page 125, Chapter 4.

8. Problem 29, page 124, Chapter 4.

9. Read the article, "Is It Time to Scrap the Fusty Old P/E Ratio?" by Ben Levisohn, WSJ, Sept. 4, 2010 and answer the questions posed (Go to Media Articles and click on Interpreting Financial Statements).


Midterm Practice 2 (From MBA 648 Fall 2010)

Notes:

    • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
    • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
    • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
    • You must explain all your answers. Answers without explanations will not receive full points.
    • Answer any seven of questions 1-8. The first seven questions carry 10 points each.
    • Question 10 is a take-home question. You may use any existing on-line resources to answer it, but you may not ask any individual on the web or off for help. I must receive your answer to Q. 10 by email by midnight Wednesday, Oct. 27, 2010.

1. In July 2007, Apple had cash of $7.06 billion, current assets of $18.75 billion, current liabilitites of $7.04 billion, and inventories of $0.29 billion.

  1. What is Apple's current ratio?
  2. What is Apple's quick ratio?
  3. In July 2007, Dell had a quick ratio of 1.26 and a current ratio of 1.31. What can you say about the asset liquidity of Apple relative to Dell?

2. In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion.

  1. What are the market capitalization-to-revenue ratios (also called the price-to-sales ratio) for AMR and BABWF?
  2. What are the enterprise value-to-revenue ratios for American Airlines and British Airways?
  3. Which of these comparisons is more meaningful and why?

3. You have an investment opportunity in Japan. It requires an investment of $3 million today and will produce a cash flow of Y351 million in one year with no risk. Suppose the risk-free interest rate in the United States is 5%, the risk-free interest rate in Japan is 1%, and the current competitive exchange rate is Y113 per dollar. What is the NPV of this investment?

4. Suppose Bank One offers a risk-free interest rate of 6.0% on both savings and loans and Bank Enn offers a risk-free interest rate of 6.5% on both saving and loans.

  1. What arbitrage opportunity is available?
  2. Which bank would experience a surge in demand of loans? Which bank would receive a surge in deposits?
  3. What would you expect to happen to the interest rates the two banks are offering?

5. You have just turned 30 years old, have just received your MBA, and have accepted your first job. Now you must decide how much money to put into your retirement plan. The plan works as follows: Every dollar in the plan earns 9% per year. You cannot make withdrawals until you retire on your 70th birthday. After that point, you can make withdrawals as you see fit. You decide that you will plan to live to 100 and work until you turn 70. You estimate that to live comfortably in retirement, you will need $100,000 per year starting at the end of the first yar of retirement and ending on your one hundredth birthday. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

6. You are running a hot Internet company. Analysts predict that its earnings will grow at 40% per year for the next five years. After that, as competition increases, earnings growth is expected to slow to 6% per year and continue at the level forever. You company has just announced earnings of $3 million. What is the present value of all future earnings if the interest rate is 10%? (Assume all cashflows occur at the end of the year.)

7. In the summer of 2008, at Heathrow airport in London, Bestofthebest (BB), a private company, offered a lottery to win a Ferrari or 70,530 British pounds, equivalent at the time to about $141,060. Both the Ferrari and the money, in 100 pound notes, were on display. If the UK interest rate was 5% per year, and the dollar interest rate was 3% per year (EARs), how much did it cost the company in dollars each month to keep the cash on display? That is, what was the opportunity cost of keeping it on display rather than in a bank account?

8. Answer any five of the following questions:

  1. Explain how the financial system facilitates the sharing and transfer of risk. Provide two different examples.
  2. What is the relevance of the stock market to the concept of a corporation?
  3. What is moral hazard? Give an example in the context of a business.
  4. What happens to the control of the firm in bankruptcy?
  5. How does the market ensure that the Law of One Price holds?
  6. How does the financial system facilitate the pooling of resources? Provide two different examples.
  7. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?

9. Read the article below and answer the following questions:

Companies may be forced to follow banks’ lead and tap their shareholders
Economist, Jan 15th 2009, New York

IN 2008 battered banks scurried to raise fresh capital. As the recession bites, they will have to come back for more. Jostling with them for limited funds will be a fast-growing number of cash-strapped non-financial firms. Pain is spreading fast across the corporate world: analysts estimate that fourth-quarter profits across the S&P 500 fell by 15% year-on-year, the sixth decline in a row—the worst run on record. Days after laying off 13,500 and cutting production, Alcoa, a bellwether for earnings, announced a crushing $1.2 billion loss. Even traditionally defensive industries, such as pharmaceuticals, are suffering: Pfizer plans to lay off up to 8% of its researchers.

With banks loth to lend and credit markets still in turmoil, a tsunami of defaults seems imminent, despite the fact that credit has thawed a little in recent weeks: junk-bond spreads have fallen from their dizzying peak of 22 percentage points over government debt, and firms are paying less to issue commercial paper, widely used to finance working capital. But they will still struggle to roll over much of the $518 billion of corporate bonds and more than $1 trillion in loan facilities that, according to Citigroup, must be refinanced this year—especially given increased competition from sovereign borrowers seeking to plug deficits. Worse, a growing band of investors is using a mix of short-selling and credit-default swaps (CDSs)*** to bet against firms with heavy refinancing exposures. As their CDS spreads widen, those companies find it ever harder to sell fresh debt.

This could leave a lot of companies having to cough up big chunks of principal on top of their regular interest payments when bonds mature, just as revenues plummet. The debt-service coverage ratios (free cashflow divided by repayment obligations) of highly geared* firms are falling below the critical level of one at a pace that seems to be unprecedented, says Barrie Wilkinson of Oliver Wyman, a consultancy. Cutting interest rates to the bone does little for firms that suddenly find themselves having to repay principal.

CDS spreads imply that around 10% of American firms will be forced into default. To avoid this, those that have trouble rolling over their debt have two main options. The first is to sell assets and use the proceeds to pay down debt. But losses booked from selling at fire-sale prices could quickly wipe through thin layers of equity. The second route is to raise capital, either through a debt-for-equity swap—as GMAC, a troubled vehicle-finance and mortgage lender, has done—or a discounted offering, such as a rights issue.

Some have already taken this last route to get lenders off their backs. Britain’s Premier Foods, for instance, is planning a rights issue in exchange for banks loosening the terms of its debt covenants.** Others are likely to follow. Andrew Smithers of Smithers & Co, a research firm, expects American companies to swing from being net buyers of their own equity (through buybacks) to net sellers. Mr Wilkinson predicts a “great dilution” of existing shareholders in 2009. This could drive another round of selling in stockmarkets, he argues, which have hitherto focused only on falling profits. Fear over the need for further capital-raising contributed to the decline of banks’ shares.

Cash-poor firms would do well to move quickly. Banks that needed equity but dithered last year discovered to their cost that the pool of available capital was not limitless; they had to pay far more for it later, if they could get it at all. And stronger firms are drinking at the pool, too: Scottish & Southern, a British energy group, has just raised £479m ($704m), in part to bolster its ammunition for opportunistic deals.

As the problem grows, governments in America, Britain and Germany are starting to step in. But all this woe has a silver lining—at least for the investment bankers who have already been through it. The wave of corporate capital-raising will bring in underwriting fees that will help offset the slump in mergers and flotations. If they can find willing takers, that is.

*Note: "highly geared" means "highly levered
** Debt covenants are conditions that lenders often impose on borrowers that require them to maintain financial ratios at certain minimum levels, failing which, usually, the loan has to be repaid immediately.
*** A CDS is a contract between two parties where the buyer of the CDS makes periodic payments over the life of the contract to the seller in exchange for a commitment to a payoff if a third party defaults.

  1. What is the difference between the debt-service coverage ratio described in the article and the interest coverage ratio?
  2. After reading this article, could you sugggest some circumstances in which interest coverage ratios could be misleading?
  3. Who might use credit default swaps?
  4. "As their CDS spreads widen, those companies find it ever harder to sell fresh debt." Explain why. (Hint: this is an example of how the financial system provides information to economic agents to make optimal decisions.)

Midterm

Notes:

    • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
    • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
    • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
    • You must explain all your answers. Answers without explanations will not receive full points.
    • Answer all questions.

1. (10 points) In July 2007, Apple had cash of $7.06 billion, current assets of $18.75 billion, current liabilitites of $7.04 billion, and inventories of $0.29 billion.

  1. What is Apple's current ratio?
  2. What is Apple's quick ratio?
  3. In July 2007, Dell had a quick ratio of 1.26 and a current ratio of 1.31. What can you say about the asset liquidity of Apple relative to Dell?

2. (10 points) In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion.

  1. What are the market capitalization-to-revenue ratios (also called the price-to-sales ratio) for AMR and BABWF?
  2. What are the enterprise value-to-revenue ratios for American Airlines and British Airways?
  3. Which of these comparisons is more meaningful and why?

3. (10 points) You have an investment opportunity in Japan. It requires an investment of $3 million today and will produce a cash flow of Y351 million in one year with no risk. Suppose the risk-free interest rate in the United States is 5%, the risk-free interest rate in Japan is 1%, and the current competitive exchange rate is Y113 per dollar. What is the NPV of this investment?

4. (10 points) Suppose Bank One offers a risk-free interest rate of 6.0% on both savings and loans and Bank Enn offers a risk-free interest rate of 6.5% on both saving and loans.

  1. What arbitrage opportunity is available?
  2. Which bank would experience a surge in demand of loans? Which bank would receive a surge in deposits?
  3. What would you expect to happen to the interest rates the two banks are offering?

5. (20 points) You have just turned 30 years old, have just received your MBA, and have accepted your first job. But you have started thinking about your retirement, like a prudent person. You decide that you will plan to live to 100 and work until you turn 70. You estimate that to live comfortably in retirement, you will need $100,000 per year starting at the end of the first yar of retirement and ending on your one hundredth birthday. If you had to put money aside today, how much money would you have to put aside in order to fund your retirement, assuming rates of return are 9%?

You do have an alternative to putting aside the money today -- you have access to a retirement plan; but you must decide how much money to put into your retirement plan. The plan works as follows: every dollar in the plan earns 9% per year. You cannot make withdrawals until you retire on your 70th birthday. After that point, you can make withdrawals as you see fit. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

6. (10 points) You are running a hot Internet company. Analysts predict that its earnings will grow at 40% per year for the next five years. After that, as competition increases, earnings growth is expected to slow to 6% per year and continue at the level forever. You company has just announced earnings of $3 million. What is the present value of all future earnings if the interest rate is 10%? (Assume all cashflows occur at the end of the year.)

7. (20 points) Answer any four of the following questions:

  1. What is adverse selection? Give an example of adverse selection in the context of a corporation.
  2. What is moral hazard? Give an example in the context of a business.
  3. How does the financial system facilitate the pooling of resources? Provide two different examples.
  4. How might one argue against using stock prices as measures of stockholder wealth?
  5. What are some of the potential social costs and benefits of the operation of a firm that do not accrue to or borne by the firm? What is the problem with not having these social benefits accrue to the firm or having these costs affecting the firm? How are some of these costs and benefits internalized?

8. (10 points) Read the article below and write two short paragraphs in clear English (no more than one and a half pages in total) explaining whether the court's decision is conducive to shareholder value maximization. You must mention arguments in the article that are for and against your position.

'Poison Pill' Lives As Airgas Wins Case

WSJ, February 16, 2011 by Gina Chon

In a closely watched decision, the Delaware Chancery Court upheld the "poison pill" strategy that companies have used for decades to protect themselves from hostile takeovers.

The court ruled in favor of Airgas Inc., which has a poison pill in place that has blocked a $5.9 billion hostile bid from Air Products & Chemicals Inc. for the past year. The pill, or shareholder rights plan, "poisons" a takeover by making it prohibitively expensive to acquire a certain percentage of company shares, typically more than 20%.

Minutes after the judge's ruling, Air Products dropped its effort to buy Airgas, taking a parting shot at Airgas's board, saying that it was "thoroughly entrenched in its position."

The landmark decision from Chancery Court Judge William Chandler was being closely watched because it could have shifted the power to decide whether a deal would take place from a company's board to shareholders.

Wall Street lawyers had been seeking clarity on the question of if and when the balance of power should shift to shareholders in takeover situation, but hadn't been given an answer because many pill cases are settled or bids are dropped before courts have a chance to make a decision.

Chancellor Chandler, in his ruling Tuesday, said the "power to defeat an inadequate hostile tender offer ultimately lies with the board of directors." As a result, he said the Airgas poison pill was a reasonable response to Air Products' offer, which Airgas has continually described as being inadequate.

Air Products, which made its hostile bid last February, argued the pill had done its job of giving Airgas's board enough time to find alternatives to Air Products' offer of $70 a share.

Now that a year has passed, Air Products said that Airgas shouldn't be allowed to continue to reject its overtures. Air Products also says Airgas's shareholders, many of whom are merger arbitragers and have been pressing for a sale, should now be allowed to decide Airgas's fate.

Chancellor Chandler noted in his opinion that Airgas has been "given more time than any litigated poison pill in Delaware history."

He said his decision wasn't an endorsement of a company's ability to say no to a deal indefinitely. Rather, he said his opinion supports the Delaware court's long tradition of respecting "managerial discretion" so long as the board is found to be acting in good faith and abiding by its fiduciary duties.

Air Products also argued that the Airgas pill should be pulled in light of the company's staggered board, a structure in which different directors are eligible for election over different years. That makes it impossible for a hostile bidder to replace them all at one annual meeting.

The ruling has national implications because most major U.S. companies are incorporated in Delaware, partly because they see the courts there are being friendly to management. The decision is seen as helping Delaware maintain that position.

Soon after the ruling, Air Products Chairman and Chief Executive John E. McGlade said in a statement that the company is withdrawing its offer for Airgas and "moving on."

"We are disappointed by the court's decision," he said. "We believe the Airgas Board of Directors has done a great disservice to Airgas shareholders by never allowing them to decide for themselves whether they want to accept our $70 per share all-cash offer. It is abundantly clear that the Airgas Board is thoroughly entrenched in its position, so we have decided to withdraw our offer and move on."

Airgas had demanded at least $78 for it to agree to a deal. Airgas said its rejection of the $70-a-share offer was particularly telling because it came from a board that has three new directors, elected last year after behing nominated by Air Products. Instead of campaigning for a sale, the new Airgas directors joined the rest of the board in demanding a higher price from Air Products.

Air Products won't appeal the ruling, a decision likely to disappoint the Airgas shareholders who had been pushing for a sale of the company.

Airgas shares have been trading around $63 in recent weeks. Airgas fell on Tuesday in after-hours trading to $60.75, compared with its closing price of $63.73.

Airgas Chief Executive Peter McCausland said the company was pleased with the ruling and added that "Airgas remains steadfast in its belief that Air Products' offer is clearly inadequate and is intended only to transfer the value of Airgas to Air Products at a price that does not appropriately compensate our stockholders."


Solutions to Midterm

1.

  1. Apple's current ratio is computed as CA/CL = 18.75/7.04 = 2.66.
  2. Apple's quick ratio is (CA-Inventories)/CL = (18.75 - 0.29)/7.04 = 2.62.
  3. Apple has more net liquidity in the short run.

2.

  1. The market capitalization-to-revenue ratios for AMR and BABWF are: 1.7/23.8 = 0.07143 and 2.20/13.1 = 0.1679
  2. The enterprise-value-to- revenue ratios are (1.7+11.1-4.6)/23.8 = and (2.2+4.7-2.6)/13.1 = 0.3445 and 0.3282.
  3. The enterprise-value-to-revenue ratios are more meaningful since AMR and BABWF have different leverage ratios (AMR's is much higher). Hence the market-value-to-revenue ratios are not meaningful.

3. Discounting the Y351m. to the present, using the yen interest rate of 1%, we get Y347.52; converting this to dollars at the current exchange rate, we find that this equals 347.52/113 or $3.0754m. Hence the NPV is $0.0754m. or $75,440. Keep in mind that the current exchange rate cannot be used to convert future dollars!

4.

  1. One could borrow from Bank One at 6% and lend to Bank Enn at 6.5%.
  2. Bank Enn would experience a surge in deposits and a Bank One, a surge in demand for loans.
  3. Bank Enn would drop its interest rate for deposits and Bank One would increase its interest rate for loans so that the rate would be ultimately the same for both banks.

5. Withdrawals of $100k. per year would start in year 71 and continue to year 100. The value of that amount at the time of retirement would be (100/.09)(1-(1.09)-30) = $1027.365k. The value of that today would be 1027.365/(1.09)40 = $32.7088k.

If you save $x per year (in '000s) starting at the end of the current year until your retirement at age 70, the present value of that would be (x/.09)(1-(1.09)-40) = 10.75x. Equating 10.75x to 32.7088k, we see that x = 3.04006; i.e. you need to save $3040.06 per year for 40 years.

6. The present value of earnings, for the next 5 years is 3(1.4)[1-(1.4)5/(1.1)5]/(0.1-0.4)= 32.75249. The present value as of the end of year 5 of future earnings is 3(1.4)5(1.06)/(.10-.06); discounting this to the present, we get [3(1.4)5(1.06)/(.10-.06)]/(1.1)5 = 265.49. Hence the present value of all future earnings is 32.75249 + 265.49 or $298.24 million.

7.

  1. Adverse Selection occurs because of information asymmetry before parties enter into a contract. Usually one party offers a contract, and the second party can accept or defer. Adverse selection is when the second party accepts, and has characteristics that would make the contract undesirable for the first party. For example, the riskiest individuals are most likely to buy insurance; insurance firms, however, do not have enough information to charge these individuals fair premiums.
    Similarly, investors who buy new equity issues cannot distinguish between good firms and bad firms. Hence, more bad firms than good firms tend to issue equity, whereas good firms might issue debt, whose valuation is less subject to unknown information about the firm.
  2. Moral hazard refers to a problem of information asymmetry that manifests itself in distorted incentives after two parties enter into a contract that initiates a relationship. Thus, after a firm issues debt, managers acting on behalf of stockholders have an incentive to take excessive debt or pay excessive dividends that actually reduce the value of the firm as a whole, but hurt only bondholders, while benefiting stockholders. Another example is the incentive for an insured person to take excessive risks or to take insufficient precautions to avoid risk.
  3. The financial system facilitates the pooling of resources through the creation of securities as well as by the creation of specific financial institutions that offer pooling contracts. Thus, the stock exchange allows individuals to buy shares of stock that represent very small portions of the total amount of resources required to run a firm. Similarly, mutual funds, through contracts with their customer, pool funds and then buy large amounts of stocks of many different issuers, allowing the customers of the mutual fund to buy shares in diversified portfolios.
  4. To the extent that stock markets are not informationally efficient or are excessively volatile, stock prices will not properly reflect stockholder wealth.
  5. Activities of the firm that generate benefits to others, but do not accrue to the firm or costs that are not borne by the firm are called externalities, positive in the first case and negative in the second. When there are positive or negative externalities, stockholder objectives deviate from societal objectives. For example, if pollution emissions are not taxed, it would be optimal for the firm to emit more pollution; but this would not be good for society because of the costs in terms of public health. Similarly, locating a firm or a factory in a depressed area might reduce crime in that area and thus reduce public costs of fighting crime and maintaining safety. However, if those savings are not passed on to the firm, it will not choose to spend as much on depressed areas, as it otherwise would. In both these cases, the internalization can occur by society's taking actions. In the case of pollution, the state could tax pollution; in the case of locating firms in depressed areas, the state could provide tax or other incentives to the firm.

8. One could argue that by allowing the final decision to be made by the board of directors, the court has weakened the forces that would lead to firm value maximization. On the other hand, by not allowing shareholders to vote with their feet (by simply accepting a takeover offer), the board has greater bargaining power. In the circumstances of the present case, one could note that the stock price of Airgas fell after the announcement of the court decision. On the other hand, even the directors nominated by Air Products voted against the Air Products offer!


Midterm Makeup

Notes:

    • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
    • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
    • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
    • You must explain all your answers. Answers without explanations will not receive full points.
    • Answer all questions.

1. (10 points) In March 2005, General Holdings (GH) had book value of equity of $ 116 billion, 10.2 billion shares outstanding, and a market price of $36.02 per share. GH also had cash of $10 billion, and total debt of $363 billion. Four years later, in early 2009, GH had book value of equity of $108 billion, 10.9 billion shares outstanding with market price of $11.35 per share, cash of $52 billion, and total debt of $508 billion.  Over  this period, what was the change in GH’s

    1. market capitalization?
    2. market-to-book ratio?
    3. book debt-equity ratio?
    4. market debt-equity ratio?
    5. enterprise value?

2. (10 points) Suppose the firm receives a $5.7 million order on the last day of the year.  You fill the order with $3.9 million worth of inventory. The customer picks up the entire order the same day and pays $2.6 million upfront in cash; you also issue a bill for the customer to pay the remaining balance of $3.1 million in 30 days. Suppose the firm’s tax rate is 0.0 %( i.e. ignore taxes). Determine the consequences of this transaction on each of the following:

  1. revenues
  2. receivables
  3. earnings
  4. inventory
  5. cash

3. The table below shows the no-arbitrage prices of securities A and B.

 

 

Cash flow in One Year
Security Market Price Today Weak Economy Strong Economy
Security A
$303
$0
$800
Security B
$459
$800
$0

Security C has a payoff of $800 when the economy is weak and $2400 when economy is strong. The risk free interest rate is 3.8%. The market price of the security is $1368. What is the expected return on security C? What is its risk premium?

4. You have an investment opportunity in Japan. It requires an investment of $3 million today and will produce a cash flow of ¥348 million in one year with no risk. Suppose the risk free rate in the United States is 7%, the risk free rate is Japan is 4%, and the current competitive exchange rate is ¥110 per dollar. What is the NPV of the investment? Is it a good opportunity?

5. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year and will be $1000. Each year after that, you will receive the payment on the anniversary of the last payment that is 4% of larger than the last payment. This pattern of payments will go forever. If the interest rate is 14% per year,

  1. What is today’s book value of bequest?
  2. What is the value of bequeath immediately after the first payment is made?

6. (10 points) You are shopping for a car and read the following advertisement in the newsppaer: "Own a new Spitfire! No money down. Four annual payments of just $10,000." You have shopped around and know that you can buy a SPitfire for cash foer $32,500. What is hte interest rate the dealer is advertising (what is the APR of the laon in the advertisement)? Assume that you must make the annual payments at the end of each year.

7. (20 points) Answer any four of the following questions:

  1. How does the financial system facilitate the pooling of resources? Provide two different examples.
  2. How does the financial system facilitate the sharing of information? Give three different examples.
  3. What is the purpose of the Annual Meeting from a Corporate Governance point of view?
  4. How might one argue against using stock prices as measures of stockholder wealth?
  5. What are some of the potential social costs and benefits of the operation of a firm that do not accrue to or borne by the firm? What is the problem with not having these social benefits accrue to the firm or having these costs affecting the firm? How are some of these costs and benefits internalized?

8. (10 points) Read the article below and write two short paragraphs in clear English (no more than one and a half pages in total) explaining whether the court's decision is conducive to shareholder value maximization. You must mention arguments in the article that are for and against your position.

'Poison Pill' Lives As Airgas Wins Case

WSJ, February 16, 2011 by Gina Chon

In a closely watched decision, the Delaware Chancery Court upheld the "poison pill" strategy that companies have used for decades to protect themselves from hostile takeovers.

The court ruled in favor of Airgas Inc., which has a poison pill in place that has blocked a $5.9 billion hostile bid from Air Products & Chemicals Inc. for the past year. The pill, or shareholder rights plan, "poisons" a takeover by making it prohibitively expensive to acquire a certain percentage of company shares, typically more than 20%.

Minutes after the judge's ruling, Air Products dropped its effort to buy Airgas, taking a parting shot at Airgas's board, saying that it was "thoroughly entrenched in its position."

The landmark decision from Chancery Court Judge William Chandler was being closely watched because it could have shifted the power to decide whether a deal would take place from a company's board to shareholders.

Wall Street lawyers had been seeking clarity on the question of if and when the balance of power should shift to shareholders in takeover situation, but hadn't been given an answer because many pill cases are settled or bids are dropped before courts have a chance to make a decision.

Chancellor Chandler, in his ruling Tuesday, said the "power to defeat an inadequate hostile tender offer ultimately lies with the board of directors." As a result, he said the Airgas poison pill was a reasonable response to Air Products' offer, which Airgas has continually described as being inadequate.

Air Products, which made its hostile bid last February, argued the pill had done its job of giving Airgas's board enough time to find alternatives to Air Products' offer of $70 a share.

Now that a year has passed, Air Products said that Airgas shouldn't be allowed to continue to reject its overtures. Air Products also says Airgas's shareholders, many of whom are merger arbitragers and have been pressing for a sale, should now be allowed to decide Airgas's fate.

Chancellor Chandler noted in his opinion that Airgas has been "given more time than any litigated poison pill in Delaware history."

He said his decision wasn't an endorsement of a company's ability to say no to a deal indefinitely. Rather, he said his opinion supports the Delaware court's long tradition of respecting "managerial discretion" so long as the board is found to be acting in good faith and abiding by its fiduciary duties.

Air Products also argued that the Airgas pill should be pulled in light of the company's staggered board, a structure in which different directors are eligible for election over different years. That makes it impossible for a hostile bidder to replace them all at one annual meeting.

The ruling has national implications because most major U.S. companies are incorporated in Delaware, partly because they see the courts there are being friendly to management. The decision is seen as helping Delaware maintain that position.

Soon after the ruling, Air Products Chairman and Chief Executive John E. McGlade said in a statement that the company is withdrawing its offer for Airgas and "moving on."

"We are disappointed by the court's decision," he said. "We believe the Airgas Board of Directors has done a great disservice to Airgas shareholders by never allowing them to decide for themselves whether they want to accept our $70 per share all-cash offer. It is abundantly clear that the Airgas Board is thoroughly entrenched in its position, so we have decided to withdraw our offer and move on."

Airgas had demanded at least $78 for it to agree to a deal. Airgas said its rejection of the $70-a-share offer was particularly telling because it came from a board that has three new directors, elected last year after behing nominated by Air Products. Instead of campaigning for a sale, the new Airgas directors joined the rest of the board in demanding a higher price from Air Products.

Air Products won't appeal the ruling, a decision likely to disappoint the Airgas shareholders who had been pushing for a sale of the company.

Airgas shares have been trading around $63 in recent weeks. Airgas fell on Tuesday in after-hours trading to $60.75, compared with its closing price of $63.73.

Airgas Chief Executive Peter McCausland said the company was pleased with the ruling and added that "Airgas remains steadfast in its belief that Air Products' offer is clearly inadequate and is intended only to transfer the value of Airgas to Air Products at a price that does not appropriately compensate our stockholders."


Solutions to Make-up

1. a. Market Capitalization:
2005 market capitalization: 10.2 billion shares*$36.02 per share=$367.4 billion
2009 market capitalization: 10.9 billion shares*$11.35 per share=$123.7 billion
So, the change over the period is $123.7 billion- $367.4 billion= -$243.7 billion.

b. Market-to-book ratio:
2005 Market-to-Book = $367.4 billion/$116 billion= 3.17
2009 Market-to-Book= $123.7 billion/$108 billion= 1.15
The change over this period is 1.15-3.17= -2.02

c. Book debt-equity ratio
2005 Book debt to equity: $363 billion/$116 billion=3.13
2009 Book debt to equity: $508 billion/$108 billion=4.70
The change over the period is 1.57.

d. Market debt-equity ratio:
2005 Market debt to equity: $363 billion/=$367.4 billion=0.99
2009 Market debt to equity:$508 billion/$123.7 billion=4.11
The change over the period is 4.11-0.99=3.12

e. Enterprise value = Equity + Debt - Cash:
2005 enterprise value: $367.4 billion-$10 billion+$363 billion=$720.4 billion
2009 enterprise value: $123.7 billion-$52 billion+$508 billion=$579.7 billion
The change over the period is -140.7 billion.

2.

  1. Revenues increases by $5.7 million.
  2. Receivables increases by $5.7 million-$2.6 million=$3.1 million.
  3. Earnings increases by $5.7 million-$3.9 million=$1.8 million.
  4. Inventory decreases by $3.9 million.
  5. Cash increases by $2.6 million.

3. Expected payoff= (1/2*800) + (1/2*2400)=$1600
Expected Return= ($1600-$1368)/$1368=16.96%
The risk premium is expected return minus risk free rate, i.e. The risk premium= 16.96%-3.8%=13.16%

4. The cash inflow is ¥348 million in one year; this is worth ¥348/1.04 = ¥334.615 million today.
In dollar terms, this is equal to ¥334.615/110 =$3.042 million today.
The NPV=$3.042 million-$3 million= 0.042 million > 0; so, this is a good opportunity.

5.a. To find the value, use the formula present value of the growing perpetuity, PV=C/(r-g), where C is the first payment, r is interest rate and g is the growth rate. We find that PV=$1000/(0.14-0.04) =$10000

b. To find the value of bequest immediately after the first payment is made, use the formula present value of the growing perpetuity, once more:
PV=C/(r-g), where C is the first payment, r is interest rate and g is growth rate. We find PV=$1000*1.04/(0.14-0.04)=$10400.

6. The value of the car is equal to the present value of the required payments: 32500 = (10000/r)(1-(1+r)-4). This has to be solved by trial and error. Trying 10%, we get $31,698.65. Hence the correct discount rate must be less than 10%. Trying 9.5, we get a PV of $32044.81. Hence the true interest rate is somewhat higher than 9.5%.

7.

  1. The financial system facilitates the pooling of resources through the creation of securities as well as by the creation of specific financial institutions that offer pooling contracts. Thus, the stock exchange allows individuals to buy shares of stock that represent very small portions of the total amount of resources required to run a firm. Similarly, mutual funds, through contracts with their customer, pool funds and then buy large amounts of stocks of many different issuers, allowing the customers of the mutual fund to buy shares in diversified portfolios.
  2. The financial system facilitates the sharing of information primarily through the operation of financial markets. For example, changes in the price of stocks are the result of aggregation of market information regarding the value of the assets represented by those stocks. This allows investors to decide whether to channel their investments to this sector or to that sector, to this firm or to that firm. The financial system also includes firms, such as ratings firms and financial analysis firms that provide information directly or indirectly to their customers and to market investors.
  3. The Annual Meeting gives shareholders an opportunity to ask questions and make the Board of Directors accountable to them.
  4. To the extent that stock markets are not informationally efficient or are excessively volatile, stock prices will not properly reflect stockholder wealth.
  5. Activities of the firm that generate benefits to others, but do not accrue to the firm or costs that are not borne by the firm are called externalities, positive in the first case and negative in the second. When there are positive or negative externalities, stockholder objectives deviate from societal objectives. For example, if pollution emissions are not taxed, it would be optimal for the firm to emit more pollution; but this would not be good for society because of the costs in terms of public health. Similarly, locating a firm or a factory in a depressed area might reduce crime in that area and thus reduce public costs of fighting crime and maintaining safety. However, if those savings are not passed on to the firm, it will not choose to spend as much on depressed areas, as it otherwise would. In both these cases, the internalization can occur by society's taking actions. In the case of pollution, the state could tax pollution; in the case of locating firms in depressed areas, the state could provide tax or other incentives to the firm.

8. One could argue that by allowing the final decision to be made by the board of directors, the court has weakened the forces that would lead to firm value maximization. On the other hand, by not allowing shareholders to vote with their feet (by simply accepting a takeover offer), the board has greater bargaining power. In the circumstances of the present case, one could note that the stock price of Airgas fell after the announcement of the court decision. On the other hand, even the directors nominated by Air Products voted against the Air Products offer!


Quiz

Spring 2011

  1. For a given bond, if its yield-to-maturity increases, its price will
    1. increase
    2. decrease
  2. A premium bond will always have a higher coupon than a discount bond of the same maturity, if the issuer is the same and the other terms of the bond indenture are the same.
    1. True
    2. False
  3. Long-term bond prices are:
    1. more volatile than short-term bond prices
    2. less volatile than short-term bond prices
  4. An A-rated bond is a bond of the best quality and carry the smallest degree of investment risk.
    1. True
    2. False
  5. A bond's holding period return is always greater than its yield-to-maturity.
    1. True
    2. False

Final Practice

Read the article entitled "A Patient/Fan of GTx Buys More" below from the WSJ of Nov. 10, 2010 and answer the following questions:

  1. Tony Marchese, CIO of Insiders Trend Fund LP said: "These are lottery tickets. The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low." Marchese simply meant that the uncertainty in both cases were high. Having studied asset pricing, explain how else GTx stock is be similar to a lottery ticket.
  2. Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment. Explain what Mr. Moreland might mean.
  3. The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. What are the implications of this fact for the Efficient Markets Hypothesis?

Memphis businessman and philanthropist Joseph "Pitt" Hyde III has been funding Mitchell Steiner's research since Dr. Steiner successfully treated him for prostate cancer 14 years ago. Mr. Hyde, chairman of Dr. Steiner's biopharmaceutical company, GTx Inc., made his latest investment last week, buying more than $15 million in shares in the company's stock offering.

Mr. Hyde, founder of AutoZone Inc., bought the shares at $2.80, and now owns about 35% of the company. He said he was taking advantage of a "unique opportunity to buy a large block of shares at a favorable price."

The offering, which raised a net $37.6 million to fund the company's clinical development projects, increases outstanding shares by about 39%. GTx shares traded at $2.80 Tuesday.

Tony Marchese, general partner and chief investment officer of Insiders Trend Fund LP, questioned why Mr. Hyde was the only insider to purchase shares in the latest offering and said small biotech companies, such as GTx, are a high-risk, high-reward investment.

"These are lottery tickets," he said. "The payoffs are enormous, but the costs are enormous." Cancer drugs take a long time to develop and the odds of success are low, he said.

Mr. Marchese said such stocks are not for the average investor, and should take up no more than 1% to 2% of a large, well-diversified portfolio.

Jonathan Moreland, director of research at Insiderinsights.com, said he'd recommend imitating insider buying of companies like GTx only as a trade, and not as a long-term investment.

The prices of biotech shares tend to rise before a news event, such as the release of study results or a decision by the Food and Drug Administration, as speculators buy in, Mr. Moreland said. He advised selling at least half of a position as speculators push the price higher, rather than waiting for the news to be released.

GTx has seen its stock fall after recent news events, such as the FDA's order last fall that it conduct more studies on its prostate-cancer drug candidate Toremifene. Disappointing results from a study of Toremifene in May sent the stock price to its all-time low of $1.90.

Before markets opened Tuesday, the company reported its third-quarter loss narrowed to $8.6 million from a year-earlier loss of $12 million on a 40% decrease in expenses. Revenue dropped 64% to $1.3 million on lower payments by developmental partners Ipsen Biopharm Ltd. and Merck & Co., but sales of Fareston, a breast-cancer drug that GTX bought from Orion Corp. in 2005, climbed 34% to $960,000.

In a phone interview, Dr. Steiner, the company's chief executive officer, called the FDA's decision last fall a major setback, and said it will probably take four years to do the work necessary to submit the drug for FDA approval.

He said, however, that the company and the agency have agreed on a plan that he expects to lead to approval for the drug, which is being developed to reduce bone fractures in men with prostate cancer.

 


Final Exam

Notes:

    • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
    • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
    • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
    • You must explain all your answers. Answers without explanations will not receive full points.
    • Answer all questions.

1. (12 points) You work for a pharmaceutical company that has developed a new drug. The patent on the drug will last 17 years. You expect that the drug's profits will be $5 million in its first year and that this amount will grow at a rate of 3% per year for the next 17 years. Once this patent expires, other pharemaceutical companies will be able to produce the same drug and competitoin will likely drive profits to zero. What is the present value of the new drug if the discount rate is 7% per year.

2. (12 points) DFB Inc. expects earnings this year of $5.13 per share and it plans to pay a $2.96 dividend to shareholders. DFB will retain $2.17 per share of its earnings to reinvest in new projects with an expected return of 14.7% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares.

  1. What growth rate in earnings would you forecast for DFB?
  2. If DFB's equity cost of capital is 11.8%, what price would you estimate for DFB stock?

3. (12 points) Identify each of the following risks to be systematic risks or diversifiable risks and explain your answer in each case:

  1. The risk that your main production plan is shut down due to a tornado.
  2. The risk that the economy slows, decreasing demand for your firm's products.
  3. The risk that your best employees will be hired away.
  4. The risk that the new product you expect your R&D division to produce will not materialize.

4. (12 points) You decide HomeNet has the following assumptions: Sales of 50,000 units in year 1 increasing by 47,000 units per year over the life of hte project, a year 1 sales price of $260/unit, decreasing by 10% annually and a year 1 cost of $120/unit decreasing by 21% annually In addition, new tax laws allow you to depreciate the equipment, costing $7.5 million, over three years using straight-line depreciation. R&D expenses total $15 million in year 0 and selling, general, and administrative expenses (SGA) are $2.8 million per year (assuming there is no cannibalization). Under these assumptions the unlevered net income is shown below in hte table:

Year 0 1 2 3 4 5
Sales
-
13000
22698
30326
36202
-
Cost of Goods Sold
-
(6000)
(9196)
(10784)
(11300)
-
Gross Profits
-
7000
13502
19542
24902
-
SG&A
-
(2800)
(2800)
(2800)
(2800)
-
R&D
(15000)
-
-
-
-
-
Depreciation
-
(2500)
(2500)
(2500)
-
-
EBIT
(15000)
1700
8202
14242
22102
-
Income tax at 40%
6000
(680)
(3281)
(5697)
(8841)
-
Unlevered Net Income
(9000)
1020
4921
8545
13261
-

Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to custromers). Furthermore, assume that HomeNet will have no working capital requirements.

  1. Calculate HomeNet's FCF for each year.
  2. If the discount rate is 10%, is the project worth investing in?

5. (12 points) Suppose a 5-year $1000 bond has a price of $1100 and a yield-to-maturity of 6%. What is the bond's coupon rate?

6. (20 points) Answer any four of the following questions:

  1. Your friend believes he has spotted the following pattern -- if the market goes up on two successive days, it always goes up on the third day, as well. Do you believe that it would be possible to make money off this pattern? Why or why not?
  2. Which prices are more volatile -- those of long-term bonds or those of short-term bonds? Why?
  3. How would you measure the beta of an asset that is traded?
  4. Sasha goes to his boss and suggests using a currently unused floor of the company's building to operate a new venture. His boss imputes a cost for the use of the unused space and finds that Sasha's project is unprofitable. Sasha objects and says that the floor is not being used anyway -- hence the implicit cost assigned to the space should be zero! What do you think?
  5. Can we say that the stock price is the discounted present value of the firm's future earnings?

7. (20 points) Read the article below and answer the following questions:

  1. What would you infer from the fact that a particular bond was trading at a higher spread over Treasuries than another bond, assuming that both bonds were priced correctly?
  2. Why does John Duensing believe that financial sector bonds are a good buy?
  3. What evidence is available to suggest that John Duensing might be wrong?

Bank Bonds: Beware

WSJ, April 2, 2011 by Ben Levisohn

Since the financial crisis, prices in most sectors of the corporate-bond market have returned to a state that can loosely be described as "normal." Financials, however, haven't—and that has made them enticing to some fund managers and strategists.

Investors shouldn't take the bait.

One of Wall Street's favored bond-valuation metrics is the "spread," or the difference between a bond's yield and an equivalent Treasury. On a spread basis, most bond categories are near their historical averages. The typical investment-grade bond issued by an industrial company, for instance, now trades at a 1.3 percentage-point spread over an equivalent Treasury, near its 14-year average of 1.6 points.

The debt of investment-grade financial companies, however, is yielding 1.9 percentage points more than an equivalent Treasury, up from the average of 1.7 points.

Since yields and prices move in opposite directions, financials seem attractively priced relative to their industrial counterparts. "The spread that exists between financials and industrials should continue to close," says John Duensing, head of corporate credit at asset manager Smith Breeden Associates.

The yield advantage is one of the reasons strategists are recommending—and investors are buying—financial-sector bonds. Barclays Capital, J.P. Morgan Chase & Co., Citigroup Inc. and Allianz SE's Pacific Investment Management Co., home of the world's largest bond fund, all have recently touted the sector.

But one corner of the market is casting a wary eye. Credit-default swaps, a way to bet on the possibility of a bond default, are currently pricing in a default rate of 11% for European financial bonds, according to Deutsche Bank AG research.

That implies a rating of Ba2-Ba3 on the Moody's Investors Service scale—deep inside high-yield territory, also known as "junk." Nonfinancial companies are being priced three grades higher, in investment-grade territory, according to Deutsche Bank.

In the U.S., banks aren't included in any of the commonly traded indices. Yet credit default swaps on individual institutions also trade at levels suggesting a higher-than-historical level of default—albeit not as large as European banks.

On a historical basis, the market may be pricing in too much bad news. Since 1920, only 0.7% of AA-rated bonds, where most financial companies resided before 2008, have defaulted during a five-year period, according to Deutsche Bank. Start in 1970, when the data get more reliable, and the figure drops to 0.3%.

But defaults among financials have been low until now in large part because governments have stepped in to prop up their financial systems during times of stress stretching back to the Great Depression. That may not be true in the future, as cash-strapped governments grow warier of "too big to fail" financial institutions.

"How all this pans out depends on government support and the conditions at the time support is needed," says Jim Reid, global head of fundamental credit strategy at Deutsche Bank in London.

Even those who like the bonds say spreads are unlikely to return to pre-crisis levels, when financial-sector bonds traded at spreads about 0.3 percentage point lower than industrial-sector debt. A better estimate, according to a Barclays Capital report, would be about 0.3 point higher. That would imply there is only about 0.2 point of tightening left.

That isn't enough of an opportunity to tempt buy-and-hold investors. Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, has looked at insurance-company bonds, but has avoided most banks. "There's still leverage to take down, and the housing crisis needs to be worked out," he says. "We're just staying away."

Thomas Atteberry, the Los Angeles-based manager of the $3.7 billion FPA New Income Fund, is avoiding the financial sector altogether. He says banks remain too difficult to analyze and aren't worth the risk.

"You need to step back as an investor, look at the yield and ask whether you're compensated for the risk you're taking in financial services companies," says Mr. Atteberry. "We're not finding value."

 


Solutions to Final Exam

  1. This is a 17-year growing annuity. The formula for the growing annuity is: PV=as(1-(as), where C is the first year profit, r is the interest rate, g is the growth rate,  and N is the number of periods. Plugging in the numbers, we get PV=($5,000,000/(0.07-0.03))*(1-(1.03/1.07)17) = =125,000,000*(1-0.523249) =$59,593,875.


  2. a. The company’s growth rate in earnings is proportional to its retention rate and the return it can get from its new investments. Thus, Earnings Growth Rate= Retention Rate*Return on New Investments. Substituting the appropriate values, we get (2.17/5.13)*14.7% = 6.22%.
    b. According to constant dividend method,  the value of the firm depends upon dividends for the next year, divided by the equity cost of capital adjusted by growth rate. Thus, P0=sd , where, P0 is current stock price per share, Div1 is the next dividend payment, RE is equity cost of capital, and g is expected dividend growth rate. For the constant payout ratio, the expected dividend growth is equal to the expected earnings growth; in this case, g=6.22%. Thus, P0=2.96/(0.118-0.0622) = $53.05.

  3. Systematic risk/Diversifiable risks:
    1. The risk that your main production plan is shut down due to a tornado. Diversifiable risk
    2. The risk that the economy slows, decreasing demand for your firm’s products. Systematic risk.
    3. The risk that your best employees will be hired away. Diversifiable.
    4. The risk that the new product you expect your R&D division to produce will not materialize. Diversifiable risk.


  4. Year

    0

    1

    2

    3

    4

    5

    Sales

    -

    13000

    22698

    30326

    36202

    -

    Cost of goods sold

    -

    -6000

    -9196

    -10784

    -11300

    -

    Gross Profits

    -

    7000

    13502

    19542

    24902

    -

    SG&A

    -

    -2800

    -2800

    -2800

    -2800

    -

    R&D

    -15000

    -

    -

    -

    -

    -

    Depreciation

    -

    -2500

    -2500

    -2500

    -

    -

    EBIT

    -15000

    1700

    8202

    14242

    22102

    -

    Income Tax at 40%

    6000

    -680

    -3281

    -5697

    -8841

    -

    Unlevered Net Income

    -9000

    1020

    4921

    8545

    13261

    -

    Suppose that HomeNet Will have no incremental cash or inventory requirements, which implies that products will be shipped directly from contract manufacturer to customers.  Furthermore, assume that HomeNet will have no working capital requirements.
    Since there are no working capital requirements, free cash flow can be computed by taking unlevered net income, adding back depreciation and adjusting for capital expenditures and other cashflows.

    Year

    0

    1

    2

    3

    4

    5

    Unlevered Net Income

    -9000

    1020

    4921

    8545

    13261

    -

    Plus: Depreciation

    -

    2500

    2500

    2500

    -

    -

    Minus: Capital Expenditures

    -7500

    -

    -

    -

    -

    -

    Free Cash Flow -16500 3520

    7421

    11045

    13261

     

    Present Value (at 10%

    -16500

    3200

    6133.06 8298.27 9057.44

    -


    The NPV, thus, works out to $10,188.71 (in '000s). Hence the project is worth taking.

  5. The price can be solved as P=C*sd *(1-sd)+sd, where C is the coupon in dollars, where P=$1100, y=6%, FV=$1000, assuming annual coupons. Solving, we find $1100=C*(1-sd)+sd, or C = $83.74. Hence the coupon rate is 83.74/1000=8.374%.



    1. It would be difficult to make money off this pattern. Once the pattern is noticed by other traders, they will all want to capitalize on it. Hence they would buy on the second day in expectations of the rise on the third day. This would cause the price to rise on the second day itself. Finally, expectations of the second day rise would cause the entire increase to happen on the first day. Thus, knowledge of the pattern itself would tend to destroy the pattern and prevent the ability to make money off it.
    2. Long-term bonds are more volatile. This is because changes in interest rates affect cash flows (coupon payments) over many periods. Furthermore, the discount factor for farther cash flows is affected much more in percentage terms for a given change in interest rates because the discounting function is nonlinear. However, the lower volatility of longer-term yields causes longer-term bond price volatility to be less than it would be otherwise. Nevertheless, longer-term bonds are, indeed, more volatile than shorter-term bonds.
    3. The easiest way to do this is to regress asset returns on returns on a diversified index such as the S&P 500. The estimated slope coefficient is an estimate of the beta. There could be problems with such a beta particularly if not enough observations are available, but the estimated beta is, nevertheless a useful first-pass estimate.
    4. Even if the space is currently not used, there is still an opportunity cost to the use of the space. This implict cost should be imputed to the space. If the project were not to be taken, then that space should be rented out, optimally.
    5. This is true only if all earnings are paid out as earnings. Else, the dividends would differ from the earnings by the amount of the reinvested earnings. If these investments are positive NPV ones, then the true price would end up being greater than the price computed by simply discounting earnings.

    1. The most obvious inference would be that the bond with a larger spread was more risky.
    2. John Duensing notes that the spreads on investment-grade financials are higher than has historically been the case. He believes, therefore, that prices will rise when the spreads go back to their historical yields, investors in these bonds will have made a profit. He clearly doesn't believe that the higher spreads are due to higher risk.
    3. One evidence that Duensing is wrong is the fact that credit default swaps on financial bonds are pricing in a higher default rate than non-financials, thus suggesting that the market thinks that financial bonds are riskier than non-financials.

 

 

 

 

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