2. The total value is initially (10 million)($20) = $200 million. The company receives $10 million from the CEO and spends $20 million repurchasing shares. Its total assets drop to $190 million and its value per share falls to ($190 million)/(10 million) = $19.

3. [Lew Sichelman, “How to Resolve the Great Points vs. Mortgage Rate Debate,” Los Angeles Times, February 20, 2000.]

a. The monthly saving is $665 - $600 = $65, and (5.75%)($100,000)/$65/month = 88 months.

b. It should be a present value calculation and it should take into account the difference in the unpaid balance.

c. For different repayment dates n, calculate the unpaid balances and compare the present values of the cash flows at the borrower’s required return:

The difference in present values is

It turns out that the breakeven repayment date n is equal to 120 months is R = 0.06 and is equal to 128 months if R = 0.07.

4. The federal funds rate is the interest rate on large overnight loans among banks and other depository institutions of reserves deposited at Federal Reserve Banks. Changes in this rate has ripple effects on other interest rates. However, if everyone expects the rate cut, it should already be reflected in long-term interest rates. Also, a cut in a very short-term rate won’t affect long-term rates much if the rate cut is expected to be short-lived. The delay gives her less time to benefit from refinancing at a lower rate.

5. Perhaps Motorola believes that future short-term rates will be higher than the implicit rates embedded in the term structure and wants to bet against the term structure. Or perhaps it is more concerned with income risk than with capital risk; i. e., it is concerned than a sharp increase in interest rates would push its interest obligations so high that it might be forced into bankruptcy.

6. a. The table:

b. The value of the firm is the dividends discounted by the stockholders’ 10% required return:

7. Not surprisingly, it gives the same answer as the dividend-discount model:

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

a. a 30-year 8%-coupon bond with an 8% yield to maturity.

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

c. a 10-year zero with a 6% yield to maturity.

9. [Jeremy Siegel, “Big-Cap Tech Stocks Are a Sucker Bet,” The Wall Street Journal, March 14, 2000; Henry N. Goldstein, “a ‘Buy’ or a ‘Steal’?,” letter to the editor.] Goldstein assumes that the stock’s price is constant for 10 years. Because the stock pays no dividends, shareholders would then have a 0% return for 10 years. Siegel assumes that investors in such a risky stock require a 15% return, which they get from the stock’s price increasing 15% a year. Siegel’s approach makes more sense.

10. 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.