2. Suppose a company has 10 million shares outstanding that are currently trading for $20 a share. The company’s board of directors unexpectedly gives the chief executive officer a bonus by allowing him to purchase 1 million new shares at $10, and he immediately does so. Simultaneously, the company sterilizes this new issue by repurchasing 1 million shares from the company’s shareholders at $20/share. Assuming no change in the company’s operations, what is the theoretical new value of the company’s shares?

3. Lew Sichelman, a syndicated real estate columnist, gave this advice on how to choose between these two $100,000 30-year, fixed-rate mortgages:

“At 6%, you’d have to keep the house seven years and four months ... before the extra amount you pay every month adds up to more than the extra money you’ll pay at settlement. If you don’t stay that long, you’ll save money by making higher payments.”

a. How did he come up with seven years and four months?

b. Why is this calculation logically flawed?

c. Explain exactly how you would choose between these two options.

4. A colleague said that s/he is going to wait to refinance his/her home mortgage until after the next Federal Open Market Committee (FOMC) meeting, since everyone expects the Fed to vote to reduce the federal funds rate at this meeting. What would you advise?

5. Motorola plans to raise up to $1.4 billion, mostly by issuing long-term debt, and will use the proceeds to eliminate its short-term debt. With the term structure upward sloping, why might it want to do this?

6. A company has no debt and currently has $100 in assets. It will earn a 30% profit rate on its assets for the next two years and a 10% profit rate on its assets every year thereafter. All of its profits for the first year will be reinvested in the firm at the end of the first year; similarly, all of its profits for the second year will be reinvested in the firm at the end of the second year. All of its profits for the third year will be paid out as a dividend at the end of the third year; all of its profits for the fourth year will be paid out as a dividend at the end of the fourth year; and so on with all future profits paid out as dividends.

a. Fill in this table:

b. If the firm’s stockholders require a 10% return, use the dividend-discount model to determine the current value of the firm.

7. Use the EVA model to value the firm described in Exercise 6. (Remember that in the EVA model the value of the firm exceeds its book value by the discounted future differences between the firm’s profit and the stockholders’ required profit.)

8. For each of the following pairs, identify the asset with the longer duration:

a. a conventional 30-year mortgage at 8% or a 30-year 8%-coupon bond with an 8% yield to maturity.

b. a 5-year zero with a 5% yield to maturity or a 10-year zero with a 10% yield to maturity.

c. a 10-year 7%-coupon bond with a 5% yield to maturity or a 10-year zero with a 6% yield to maturity.

9. In March 2000, Wharton professor Jeremy Siegel wrote a Wall Street Journal article arguing that the price-earnings ratios for large tech stocks were probably not justified. For example, JDS Uniphase had a 1999 P/E of 668.3, paid no dividends, and had a total market value of $99 billion. Analysts’ seemingly optimistic prediction was that its earnings would grow at 44% a year for the next 5 years. Siegel calculated that if its earnings grew at 44% a year for 10 years and “investors expect to receive an average 15% annual return,” its P/E ratio in 10 years would be 68.3. Henry Goldstein, professor emeritus of economics at the University of Oregon, responded by arguing that “the latest Barron’s gives a consensus earnings forecast of $1.09 a share for JDSU for 2001. If such earnings were to rise by 44% annually over the following 9 years, the company’s earnings in 2010 would be $29.02 per share. With the stock’s price constant at its recent ... level of $266 per share, its P/E in 2010 would then be a mere 9.2. So: Is this stock ‘a buy’ or ‘a steal’.”?

Do not check their calculations. Instead identify the logical error that explains their quite different conclusions. In your opinion, which economist’s approach makes more sense?

10. A famous stock adviser once argued that a conspiracy between stock specialists and bankers is suggested by the fact that “when you’re having a decline in stock prices you can always anticipate an increase in interest rates.” What he apparently meant is that when specialists and market makers lower stock prices so that insiders can accumulate stocks cheaply, banks raise interest rates so that the public cannot borrow money to purchase stocks at these bargain prices. Provide a reasonable non-conspiratorial explanation for the observation that a drop in stock prices is often accompanied by an increase in interest rates.