1. These are separate: (a) the company's operations, which generate cash flow for the the stockholders; and (b) the value that the stockholders place on the company's shares. Think of the hamburger stand example. The stand makes $200,000 a year, which it gives to stockholders as dividends. The value of the company’s stock is what stockholders will pay to receive $200,000 a year. This might be $1,000,000 or $2,000,000–depending on their required rate of return.

The actual trading of the stock occurs in the secondary market and does not provide any cash flow to the company; it is just investors trading stock for cash among themselves. They can bid up the price of the stock because they believe that they will be able to sell the stock to someone else for more than they paid for it. But this rise in the stock's price has no effect on the company's operations or its cash flow. It is the exact same company with the exact same cash flow as before, but a speculative frenzy has increased the price of its stock. If there comes a time when stockholders realize that the company is never going to be profitable and that the price of the stock is not going to keep increasing, the price of the stock will collapse. Who would pay $1 million for shares in a company that doesn't make any profits?

2. Inflation does reduce the real value of fixed-income securities. But if inflation is the order of the day, such inflation expectations will presumably already be reflected in low prices and high yields for fixed-income securities. Inflation risk refers to the possibility of unanticipated inflation.

3. [Ruth Simon, "Hedging a Single Stock Has Ups, Downs," The Wall Street Journal, February 2, 2000.] It is called a zero-cash collar because the net cost of the implicit put and call is $0. The right to sell 100,000 shares to his broker for $22.37 is equivalent to purchasing a put with a $22.37 strike price; the obligation to sell 100,000 shares to his broker for $30.07 is equivalent to selling a call with a $30.07 strike price:

4. a.

Here are some illustrative calculations:

b. If the payments started next year (instead of 21 years from now), the present value would be:

This would be like a $1,000,000 loan, with 3% interest paid each year on the unpaid balance. Therefore, the present value at a 3% required return is exactly $1,000,000. Since the payments do not actually start for 21 years, the present value is less than $1,000,000. In fact, it is Pb/(1.03)10 = 553,675.75

5. Logically, there is no compelling reason why each P/E should be constant. Mathematically, if each P/E is constant, both prices will increase by 1%! If P = (P/E)E and (P/E) is constant, then P and E change proportionately; if E is up x%, then P must also increase by x% to keep P/E constant. For example, suppose P/E = 10. If E = 10, then P = 100, if E increases by 10% to 11, then a constant P/E requires P to also increase by 10%, to 110.

6. Not unless the profit rate on these acquisitions and expanded operations exceed the shareholders’ required rate of return.

7. a. Because the United Kingdom experienced a faster rate of inflation than the United States between 1976 and 1988, the pound should have depreciated relative to the dollar. (Equivalently, the dollar should have appreciated relative to the pound.)

b. The fact that the exchange rate was virtually the same in 1988 and 1976 suggests that U.S. goods were cheaper than U.K. goods in 1988, causing U.S. exports to the U.K. to exceed U.S. imports from the U.K.

c. If no change in the value of the dollar relative to the pound was anticipated, the interest rates should have been the same!

8. a. The falling yields on 0%-coupon bonds tells us that the term structure is downward sloping. The expectations hypothesis says that this is because interest rates are expected to decline. Because of this anticipated decline in interest rates, the relatively large 10% coupons bond will be reinvested at progressively lower interest rates; the 10% coupon bonds must consequently have relatively high yields to maturity for them to do as well as lower-coupon bonds.

9. (1) A. The payback periods are 1 year for A and 2 years for B

(2) A. Using the consol formula, 8 = 4 + 4/R, A’s IRR is 100%. For B, we have 8 = 6/R, which implies R = 6/8 = 0.75 (75%).

(3) B has the higher NPV for any required return less than 50%. Using the consol formula NPVA = - 8 + 4 + 4/R = - 4 + 4/R and NPVB = - 8 + 6/R. They are equal at 4 = 2/R, which implies R = 2/4 = 0.50 (50%).

Here is a graph:

10. [Motley Fool Tax Tips, Wednesday, September 13, 2000. http://www.fool.com/m.asp?i=121237] If the return on the market is x% larger (or smaller) than expected, the expected return on a stock is beta*x% larger (or smaller) than expected. However, the return on the stock will not be exactly beta*x% larger (or smaller) than expected, unless the R-squared is 1. A stock’s volatility also depends on its idiosyncratic risk. A stock can have a low beta and still be very volatile.