1. Here is an excerpt from a case study of EG Corporation: "What Ralph [the chief executive officer] found was disturbing--and revealing. EG's return to investors had indeed been below the market overall and below the returns for a roughly assembled set of •comparable' companies. What also stood out from the analysis were a couple of events that had knocked down the value of EG relative to the market. In the period 1980 to 1985, EG had made several acquisitions to establish and build the Woodco furniture businesses. Ralph noticed a decline in EGs share price relative to comparables and the market around the date of each acquisition. In fact, when the team calculated the impact of these declines on EG's total value, they realized that the decline in EG's total value was about equal to the dollar amount of the the premiums over market price EG had paid to acquire the companies." [pp. 36-37]

   a. Under what circumstances would an acquisition have this effect on the wealth of the shareholders of the acquisition company?

   b. What do you think happened to the wealth of the shareholders of the target companies?

2. "EG had sizable and stable free cash flows that could support much higher debt. The Consumerco business, which generated the bulk of the cash, was recession-resistant....[B]eing considered investment grade or not was irrelevant....EG could raise $500 million in new debt in the next six months and use the proceeds to repurchase shares or pay a special dividend. This debt would be worth about $200 million in present value to EG's shareholders." [pp. 46-47.]

   a. Why is it important that EG be recession-resistant?

   b. How could shareholders possibly benefit from the issuance of debt that leads to a downgrading of the company's rating from investment grade?

   c. How do you suppose McKinsey calculated the $200 million additional value for shareholders? (Hint: It was an extremely simple calculation.)

3. Finish the following sentence. When the term structure is upward sloping, a "bank that lends three-year money and borrows one-year money will earn a mismatch profit equal to the difference between the longer- and shorter-term rates of interest. However, much of this profit is illusory because..." [pp. 383-4]

4. Explain this formula [p. 79] "that allows us to predict the P/E ratios of the two companies"

where
g = the long-run growth rate in earnings and cash flow
r = the rate of return earned on new investment
k = the discount rate

5. "On October 1, 1974, the Wall Street Journal published an editorial lamenting the widespread focus on earnings per share as an indicator of value:

A lot of executives believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb....The market is smart. Apparently the dumb one is the corporate executive caught up in the earnings-per-share mystique.

   Unfortunately, our experience shows that many corporate managers still worship earnings per share, and thus are still betting that the market is dumb." [p. 73]       Identify two different management policies that boost earnings per share, but should not increase (and may even decrease) shareholder wealth. (Do not use mindless speculation or fraudulent accounting as examples.) Explain your reasoning.

6. In the following quotation [pp. 134-135], there are four bracketed choices. In each case, circle the most appropriate word:

We can derive the expected general inflation rate that is consistent with the discount rate from the term structure of interest rates....Exhibit 5.9 shows the term structure of interest rates at three points in time. Inflationary expectations are clearly reflected in each. In 1981, short-term interest rates were high, reflecting the market’s belief that future inflation would be [higher/lower] than near-term inflation. In 1984, inflationary expectations were [higher/lower] than in 1981, and the market believed long-term inflation would be [higher/lower] than short-term inflation. In 1988, inflationary expectations were even [higher/lower].

7. In valuing a company's stock, McKinsey recommends adding a company-specific risk premium to a risk-free rate of return. For the risk-free return, they suggest the interest rate on government securities that have a duration comparable to that of stocks. [p. 192]

   a. What kind of risk are government securities free of?

   b. Why would the value of corporate stock depend on the interest rate on a government bond?

   c. Why would you want to use a bond with a duration comparable to that on stocks?

   d. Does the duration of T-bills or 10-year T-bonds more nearly match the duration of the S&P 500? Explain.

8. The U.S. government will soon be selling inflation-indexed securities, with the principal and interest increasing each year by the percentage change in the consumer price index. Consider an inflation-indexed consol bond that will pay $100 each year forever if there is never a change in the CPI. If prices do change by x% in any year than the payment that year will be x% higher than the payment the previous year.

   a. If the rate of inflation turns out to be 4% for each of the first five years and then 2% for every year thereafter, how large will the payment be in the 20th year?

   b. If you require an annual real return of 2.5%, how much would you pay for this bond?

9. A recent New York Times article began: "Is the Q ratio signaling that the end is near for this great bull market? The what? If you're an economist, you didn't even ask the second question." The article went on to point out that Q was 1.7 at that time and quoted a British pension consulting firm: "Professor Tobin received a Nobel prize for his work, and the U.S. stock market may thus be said to be making a bet of approximately $3 trillion that he should return his laurels. I expect him to be justified in keeping them."

   a. How is Q calculated?

   b. How do you suppose the $3 trillion figure was calculated?

   c. Use the constant-dividend-growth model to explain why a Q ratio of even 2.0 might be completely rational. Use some plausible hypothetical numbers to make your arguments more concrete.

10. Explain the following news story [Farrell Kramer, "Welcome to •the World of Goldilocks'," The Arizona Republic, March 9, 1996.]:

They’ve got to be kidding.
   Wall Street's brain trust, the loud-tie-and-suspenders crowd paid extraordinary sums to make sense out of the economy, got some of the best news in years Friday: the nation created a whopping 705,000 jobs last month. Pop the champagne? Run out and buy that new Mercedes? No way.
   Traders instead exhibited the topsy-turvey logic that has come to symbolize Wall Street...[S]tock traders somehow decided the companies doing all the hiring actually were worth less than a day earlier. They sold, driving the Dow Jones industrial average, the stock market's most widely watched index, down 171.24, to 5,470.45, for its third-worst point decline ever. Traders also dumped Treasury notes, figuring an improving economy makes investments in Uncle Sam less attractive.