Paraphrase Only

CH 5

1-

Common stocks are more risky than U.S. government bonds. Risk-averse investors demand higher returns on common stocks than government bonds as compensation for the added risk. If returns on government bonds were, on average, as high as those on common stocks, prices of government bonds would rise and prices of common stocks would fall as investors fled to the safer but equally promising bonds. This would result in lower expected returns on bonds for new investors and higher expected returns on stocks until the tradeoff of risk for return reappeared.

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.

3-

The percentage of the company owned is most important to the investor. This determines the size of her claims on company cash flows and, hence, the value of her investment. A company’s share price, and the number of shares outstanding, can be arbitrarily changed by splitting the shares. Share price and number of shares owned are of interest only to the extent that they help the investor calculate more meaningful dollar or percentage ownership numbers.

4- Yields on callable bonds will be higher, investor takes risk by taking the callable bonds beacuse issuer will call the bond if interest rate declines. So issuer has to compensate the investor for taking the risk by investing in callable bonds.

7-

a-

Stock Price - 8% Underpricing = Issue price

$75.00 - 6.00 = 69.00

Issue price- 7% Spread = Net to company

69.00 - 4.83 = $64.17

Number of shares = $500 million / $64.17 = 7.79 million

b- Investment bankers’ revenue = $4.83 x 7.79 million = $37.63 million

c- Underpricing is not a cash flow. It is, however, an opportunity cost to current owners because it means that more shares must be sold to raise $500 million and each existing share will represent a smaller ownership interest in the company. P.S. Opportunity costs are just as real as cash flow costs.