Econ 156
Gary Smith
Fall 2003

Second Test Answers

1

Because the maintenance/service fees are the same whether Carnegie buys or leases, we can ignore these fees. We want to compare the purchase price with the present value of the lease payments:

The breakeven R that equates the PV to $15,427 works out to be 7.3%. They should lease the copier if they can earn more than 7.3% on their money; otherwise, they should buy the machine.
2
 The valuation should depend on how fast the cash flow is projected to grow and on interest rates.
3
 For horizons beyond the duration, low interest rates reduce wealth because the reduced interest on reinvested coupons outweighs the increase in the market value of the bond. This will be true of life insurance companies with horizons of 40 years who buy bonds with durations of 8 years.
4
 If r = R, then there would be no economic value added, and P = K. The economic value added each period is the profits rK minus the cost of capital, RK: EVA = (r - R)K Using the present value of a perpetuity, the value of the firm is P = K + (r - R)K/R = r*K/R
5
 The implicit assumption is that Freddie Mac will pay more than these old low-interest loans are worth. If these loans are fairly priced to give rates of return comparable to new loans, there is no advantage to selling the old loans and making new ones.
6
 a. Option valuation models tell us that because the options have limited downside potential and unlimited upside potential, actions that increase the volatility of the stock price will increase the value of the options.
b. Conservation of value models tell us that the actual disbursement of dividends reduces the value of the company and its stock. Therefore, a reduction in the firm’s dividends increases the value of the stock. (Anticipated future changes in dividends affect current stock prices to the extent that the firm’s profit rate differs from the shareholders’ discount rate.)
7
 High-yield bonds are junk bonds.
a. Treasuries and high-yields are both bonds with promised future coupons and principal; the present values (and market prices) decline when market interest rates go up and rise when market interest rates fall.
b. Stocks, too, have a future cash flow (dividends), with a present value that is inversely related to market interest rates.
c. The correlation between Treasuries and stocks is far from perfect because, unlike Treasuries with their fixed coupons, the future cash flow from stocks is uncertain and fluctuates with the strength of the economy.
d. High-yields are evidently more closely correlated with stocks than with Treasuries because their returns are sensitive to the strength of the economy in the same direction as stocks. This makes sense, since a strong economy will not only increase stock dividends, but also make it more likely that junk-bond issuers will be able to pay their promised coupons and principal.
8
 They will lose money if interest rates go up. Therefore they want to take actions that will make money if interest rates go up.
a. No, this gives them even longer-term assets.
b. No, these will lose money if interest rates go up. They should bond sell futures.
c. No, these will lose money if bond prices go down (interest rates go up). They should sell bond calls.
d. Yes, these will make money if bond prices fall (interest rates go up).
e. No, swapping fixed-rate debts for variable-rate debts would shorten the duration of their liabilities, exacerbating the mismatch between their long-duration assets and short-duration liabilities—borrowing short to lend long.
9
 On Friday, the market value was (1.05 billion)($31.80) + (1.49 billion)($81.86) = $155.36. On Monday, the market value was V = (1.05 billion)($39.20) + (1.49 billion)($73.57) = $150.78, a decrease of $4.58 billion. Apparently, “The market feels that BofA is overpaying and may be destroying more value than it creates through cost savings,” said David Hendler, an analyst at CreditSights Inc.
10
 R = 0