1. In McKinsey's words, "Evidently, the stock market did not believe that EG would add any value to the acquired business." In accord with the conservation-of-value principle, a merger that does not create more aggregate cash flow than the two separate companies had before the merger has no effect on shareholder wealth. If the acquiring company pays a premium over the market price to acquire the company, then their shareholders' wealth drops by the size of the premium. In contrast, the wealth of the shareholders of the target company increases by the size of the premium.

2. This exercise has to do with the profitable use of debt as a tax-shield.

   a. For EG to take on new debt, it is important that the company be recession-resistant so that it is not thrown into bankruptcy by a sudden drop in profits and cash flow.

   b. The issuance of debt, even if it leads to a downgrading of the company's debt rating, can benefit shareholders by shielding a larger portion of the company's profits from taxation.

   c. By assuming a 40% tax rate, McKinsey calculated that $500 million of additional debt would reduce the company's taxes by 0.40($500 million) = $200 million. (This incorrectly assumes that all of the debt payments--principal and interest--are tax-deductible.)

3. Here is their end of the sentence: "the one-year funds must be rolled over twice at future one-year spot rates that are expected to be higher than today's one-year rate."

4. This is clearly an adaptation of the constant-dividend-growth model. Using the notation here, remember that the long-run growth rate is g = (1 - d)r. Thus g/r = 1 - d and we can rewrite the McKinsey equation as

   which is the version of the constant-dividend-growth model that we discussed in class.

5. Reinvesting earnings when the profit rate is positive, but less than shareholders' required return boosts earnings (and thus earnings per share), but reduces shareholder wealth. A reverse stock split reduces the number of shares outstanding and so increases earnings per share; however, there is no effect on shareholder wealth, except for the decrease caused by the cost of this transaction. Buying a low-P/E company boosts earnings per share (as in the Cooper-Smith merger discussed in the textbook and briefly in class); again, there is no effect on shareholder wealth, except for the decrease caused by the cost of this transaction.

6. The right words are lower, lower, higher, and lower. The most questionable assumption underlying this analysis is that the real interest rate is constant. (They assume 2.5 percent.)

7. a. Government securities are free of default risk.

   b. The value of corporate stock depends on the interest rate on a government bond, because bonds are an alternative asset for investors.

   c. You might use a bond with a duration comparable to that on stocks because they then have comparable amounts of capital risk.

   d. Treasury bills have a year or less until maturity and consequently have a duration of less than a year. The cash flow from corporate stocks is much more distant, and they consequently have a duration closer to that on ten-year Treasury bonds. (McKinsey says "the ten-year rate approximates the duration of the stock market index portfolio--for example, the S&P 500." This is actually only true if it is a ten-year zero, since stock have a duration of around 10 years.

8. 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, the payment be in the 20th year is given by this future-value formula:

   b. The present value can be determined either by discounting the nominal cash flow by the nominal required return or by discounting the real cash flow by the real required return. Here, it is clearly easiest to discount the $100 annual real cash flow by the 2.5% real required return:

9. This exercise refers to Tobin's q.

   a. Q is the ratio of the market value of firm's to the replacement cost of its assets.

   b. This consultant evidently believes that market values are too high because they are 1.7 times replacement cost, rather than equal to replacement cost. The $3 trillion figure is the difference between market value and replacement cost.

   c. Consider the hamburger stand with A = $1,000,000 and D = E = $200,000 (r = 0.20). If R = 0.10, then P = $200,000/0.10 = $2,000,000 and q = 2.

   More generally, the core equation of the constant-dividend-growth model is

   Suppose that the dividend payout rate is d = 0.5 and the profit rate is r = 0.20:

   The value of q will be 2 if R - 0.10 = 0.10/2 = 0.05, so that R = 0.15.

10. The strong economic news must have made traders wary either of renewed inflation that would push up interest rates or of an effort by the Fed to raise interest rates to slow the economy in order to prevent inflation. These higher interest rates are evident in the dumping of Treasury notes (prices down, yields up), and we know that higher interest rates pull stock prices down too.