Econ 156 Fall 2000 Midterm Answers

1. The firm may not be very profitable and/or it may have a large number of shares outstanding.

2.The monthly payments are given by

     The solution is X = $394.41. The effective interest rate is given by
     The solution is APR = 0.1588, or 15.89%.

3. The Fool looks at $3.52(1.11)10 = $10, but you do not have to wait 10 years to get the $10. Because getting $1 each year for 10 years is better than getting $10 at the end of 10 years, you would pay more than $3.52 (which is what the Fool concludes too). At an 11% required return, the present value of $1 a year for 10 years is $5.89.

4. Record profits just means that profits are growing, not that they are necessarily growing very fast; similarly, with the increased dividend for the seventh year in a row. The payment of a stock dividend has nothing to do with the firm's profitability. This simply doubles the number of shares and halves the value of each share.

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. Fundamental analysis tells us that an increase in interest rates raises shareholder required returns, reducing the present value of a given cash flow. Rather than a drop in stock prices causing interest rates to increase, it is more plausible that an increase in interest rates causes stock prices to decline.

7. a. An unanticipated increase in interest rates hurt S&Ls who had borrowed short and lent long, thereby holding assets with longer durations than their liabilities. Adjustable-rate mortgages alleviate this imbalance by reducing the duration of their assets.
     b. If the duration of their liabilities exceeds the duration of their assets, their net worth will be reduced by an unanticipated decline in interest rates. The market value of their liabilities will increase by more than the market value of their assets.
     c. Interest rates declined significantly, increasing the market value of long-term fixed-rate mortgages considerably.

8. The value of an enterprise is the present value of the cash flow it generates, not the present value of its debts. Is a company with no debt worthless? Is a company with no assets and $1 billion in debt worth $1 billion?

9. Consider the dividend-discount model,

     If the firm has a low g, then it must have a low P and high D/P to provides shareholders their required return. (Less satisfactory is the alternative explanation that firms that pay large dividends retain less and therefore grow slower; the dividend yield D/P depends on how the market values these dividends.)

10. Your return on Treasury bonds will include capital gains or losses as interest rates fluctuate. You might buy Treasury bonds on margin if you expect interest rates to decline significantly.

back