no plagiarism

1. List the three forms of market efficiency and explain the bases for them. Which do you believe to be most accurate form with respect to current equity markets and why. (6 sentence maximum)

(1) weak-form efficiency

(2) semistrong form efficiency

(3) strong-form efficiency

These distinctions are based on the level of information reflected in the security prices. Weak- form efficiency deals with historical prices. Semistrong form deals with publicly available information that also includes historical information. Lastly, strong form includes all information that can be acquired by painstaking analysis of the company and the economy.

2. Why do firms rely heavily on internal funds? (3 sentence maximum)

Internal funds, defined as depreciation plus retained earnings, make up a large portion of funds invested by U.S. corporations each year. The main reason is the cost of issuing new equity. The cost of issuing new equity is quite high, and corporations try to minimize these costs. The second reason might be to avoid the discipline of the security market.

3. Explain how shareholders might have lost control over corporations, relative to managers, over the years. (5 sentence maximum).

There are many possible answers to this question. The most relevant answer is a simple disparity of resources. Managers have access to the resources of the firm and may use those resources to enact changes in corporate governance rules or laws to which they benefit. Other than large institutional shareholders, most common stockholders have very little financial incentive to lobby their interests considering the small size of their investment, compared to the overall size of the firm. This is why most shareholder rights initiatives are led by institutional investors or large individual investors.

4. What are some of the costs to a firm associated with issuing new securities? Be specific. (3 sentence maximum).

The most important cost is the underwriter's spread, which can be as high as 7% in the case of IPOs. In addition, there are other administrative costs like preparing the registration statement and prospectus; and consulting costs for management, legal, and accounting matters. These can be substantial.

5. Briefly explain the role of underwriters in the issuance of securities. (3 sentence maximum)

The underwriters are an integral part of the securities market. Underwriters have the expertise and contacts necessary to design and distribute the securities. Underwriters provide advice and guidance in the preparation of the security issue, and price it and sell it to investors.

6. A retiree believes that investing in a nondividend paying growth firm, which requires the periodic sale of stock for income, will eventually lead to a loss of all shares. Explain the flaw in this logic. (4 sentence maximum)

A growth firm, by definition, will have an increasing share price. Over time the firm will either have stock splits to maintain a stock price within a certain trading range or the price will go up substantially over time. In the case of stock splits, the retiree will get an ever increasing number of shares. In the case of an increasing share price, the retiree will need to liquidate a decreasing quantity of shares. In either case, the investor's investment will not disappear any faster than it would through dividend payments.

7. Briefly discuss why WACC is used most often by managers to make capital budgeting decisions. What is the effect on value? (4 sentence maximum)

The after-tax weighted average cost of capital (WACC) method is the most often used method in practice. It is conceptually easy to understand and communicate. It relates well with the NPV and IRR methods. It is also used for valuing businesses.