Economics 126: 1995 Midterm Answers

Econ 126 1995 Midterm Answers

1. The required rate of return presumably includes a risk premium.

2. Solving 38,915(1 + R)^2.25 = 17,948, R = -0.2910 (-29.10%)

3. Here are the cash flows (in thousands of dollars):

Year	0	1	2	3	4	5	6	7	8	9
a.	15	0	0	0	0	0	0	0	0	0
b.	3		2		2	3		2		2

The assumption that the signs would need to be reinstalled and relettered five times is wrong. Plus, we need a present value calculation, further reducing the cost of option b, which I would recommend--its cash flow is smaller and postponed.

4. The realized rate of return is above or below the quoted yield to maturity, depending on whether the coupons can be reinvested at returns that are above or below the yield to maturity. Two alternative conditions are (a) the bond has no coupons; or (b) the coupons are reinvested at a return equal to the bond's yield to maturity.

5. The market value of a company should equal the present value of its net cash flow, not just the present value of its debts. Equivalently, the market value should equal the market value of its assets minus the market value of its debts, where the market value of its assets is determined by the present value of the cash flow (other than debt payments). Suppose, for example, that these companies can make an after-tax profit (net of debt payments) that is initially $1 billion a year and grows by 5 percent a year. At a 10 percent required return, the market value of the companies' net cash flow is $20 billion. If, on the other hand, these companies are not profitable enough to pay off their debt, their market value is negative (the government will have to pay someone to take them over).

6. As with Tobin's q, high market prices relative to construction costs make it profitable to build houses.

7. Market-value risk, due to changes in interest rates for example.

8. Borrowers voluntarily repaid their loans early because market interest rates had declined. The increased cash flow to the Bank reduced the Bank's 1987 deficit, as calculated on a cash-flow basis. These loan prepayments weakened the Bank's financial condition, in that the present value of these bank assets were presumably larger than the prepayment (otherwise the loans wouldn't have been voluntarily prepaid).

9. Here is a stylized version of the initial balance sheet (in billions of dollars), assuming that the stock's price was $25 at the time of the $28 offer:

A		L
Assets	2	Debt	1
		Equity	1

Here is the balance sheet after the issuance of debt to pay a special dividend:

A		L
Assets	2	Debt	2
		Equity	0

(a) Borrowing $1 billion in order to pay shareholders a special cash dividend of $25 a share doesn't affect the firm's assets, but essentially wipes out the equity (except for the tax shield provided by the additional debt). Shareholders are unaffected, now having $25 in cash and worthless stock in place of $25 in stock. (b) Giving top management 1.5 million shares of stock before the dividend reduces the firm's assets by $25(1.5 million) = $37.5 million, and the increase in the number of shares further reduces the price per share from assets/40 million to (assets - $37.5 million)/41.5 million; alternatively, the value of existing shares is reduced from assets/40 million to assets/41.5 million (c) Giving top management another 1.5 million shares after the dividend reduces the value of the existing shares by about 4 percent, from assets/41.5 million to assets/43 million.

10. In comparison with the 7.8% average annualized monthly price increase since 1948, the first condition seems to be good for the stock market while the other four conditions appear to be bad for stock prices. This generally makes sense: Rising corporate profits increase the potential for future dividends. High interest rates should reduce the present value of the cash flow to shareholders. A slow growth rate should reduce corporate earnings and market prices. Contrarians expect a high P/E to reduce market prices. However, unusual movements in stock prices should be caused by unexpected events, not persistent conditions; for example, not the level of interest rates, but whether they move in an unexpected direction. In addition, what matters is not conditions in isolation, but the combination of conditions; for example, the growth rate relative to shareholders' required return.