Homework Help 5

Chapter 5

2. The fact that government bonds earned a higher rate of return than common stocks in one year is not evidence that investors are suddenly willing to settle for lower returns on stocks than bonds. It means that investors’ expectations were not met, or said differently, that investors were surprised. To take on additional risk, risk-averse investors require additional expected return. But expected returns are not the same as realized returns. Because stocks and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in some years. But the expected returns on common stocks will always be higher than the expected returns on government bonds.

4. The yield on the bond with the call provision will be higher. The call option gives the issuer a valuable option and investors will demand compensation for this option in the form of a higher yield. For example, suppose the interest rate declines in year six. The price of the non-callable bond will rise as the holder earns an above market current yield, while the price of the callable bond will remain at $1,000 in anticipation that the issuer will call the bond and refinance at the new lower rate. Holders of the callable bonds will demand a higher yield to compensate for such eventualities.

6. a. The annual returns are as follows:

b. Share repurchases do not affect these calculations. Share repurchase will increase the percentage ownership of each remaining share, and will likely increase the end-of-year share price. However, this increase is already reflected in the observed end-of-year price and thus in the annual return.

8. The price will be set at 5% below the current price, or at 0.95 × 10 = $9.50. The underwriters will take $0.50 per share, leaving $9.00/share for Magenta. Magenta needs to receive $51 million (in order to have $50 million net of all fees), and it gets $9/share, so it must sell $51 million/$9=5.667 million shares.

10. a. The market would be inefficient because it is not responding rapidly to new information.

b. Buy the target’s stock immediately on the announcement. Sell in four days after it has risen and pocket a nice profit.

c. If many investors pursued this strategy, the increased demand on announcement would cause the price to jump sharply immediately after the announcement. The price response would become efficient.

d. This problem illustrates the statement quite clearly. People discover an inefficiency, and in the process of capitalizing on the inefficiency, they drive it away.

e. This is not necessarily evidence of market inefficiency. If investors expect the bid to be followed by higher bids from other potential buyers, the market will rationally and efficiently drive the price above the initial bid.

12. Earning high returns in an efficient market is like winning at roulette. In any random process, there will be winners and losers, and some winners might win big. Earning consistently high returns over time is also possible in an efficient market, just like a gambler on a lucky streak might win repeatedly at roulette. The relevant questions are whether the very high returns or the length of the winning streak is inconsistent with blind luck or not.

The continued investment success of Warren Buffett and his associated value investors does pose a challenge to market efficiency. The argument that this success is just luck stretches credulity. A more likely explanation is that high intelligence, extreme emotional discipline, and driven dedication do enable some people to earn superior market returns. At the same time, evidence tells us that these individuals are extremely few and far between, and that it is virtually impossible to identify these individuals in advance with any reliability. It should also be noted that Warren Buffett is not a passive stock picker, that much like a private equity firm, Berkshire Hathaway, adds considerable value to acquired companies via changes in operations, management, incentives, and governance practices.

14. a. This is a call option. You have the option to buy.

b. According to Robert’s Option Pricer, the value of the option per share is $4.55. You own 1,000 options, so in total they are worth $4,550.

c. $2.09 × 1,000 options = $2,090. There is a much better chance CSCO stock will rise to high levels in three years than in five months.

d. $6.37 × 1,000 options = $6,370. The more volatile CSCO stock, the more likely it will rise to high levels during the life of the option.