Econ 156

Smith

Spring 2001

Midterm Answers

1. Above its maturation value. If its price were equal to its maturation value, its yield to maturity would be equal its coupon rate: $10/$1000 = 0.01 (1%). For the yield to be lower, the price must be higher.

2. Unlike Las Vegas, which is a zero-sum game, firms produce things and make profits, thereby generating earnings that are either distributed to shareholders or reinvested in the firms’ expansion. Because firms are "dollar machines" that generate cash, they can pay dividends without shrinking. As they expand and their earnings and dividends increase, their shares are also worth more, thereby providing capital gains to shareholders.

3. If other investors are as confident as you are, these anticipated reductions will be fully embedded in the term structure, so that no excess profits are to be made.

4. After 9 years, the nest egg is

At that point in time, the present value of a $10,000 perpetuity, beginning one year hence, is 10000/R. Equating the two,

5. Not unless it can acquire Walmart and other profitable companies for less than the present value of their assets and economic value added or there are very profitable synergies or economies of scale. You can’t create value by buying something for what it is worth, unless there are synergies or economies of scale. The conservation of value tells us that the value of Yahoo plus Walmart is equal to the value of Yahoo plus the value of Walmart. If Yahoo by itself is worth nothing, the value of Yahoo plus Walmart is only equal to the value of Walmart.

6. [Eleena de Lisser, "Rent-to-Own Firm Struggles to Reassemble ‘Credibility’," The Wall Street Journal, November 7, 2000.]

a. Because all but one of the payments are made before the end of 78 weeks, the implicit rate of interest is higher than would be the case if all the payments were made at the end of 78 weeks. (The solution of the present-value equation

shows that the implicit annual interest rate is 221.98%.)

b. Higher. Giving the TV away is equivalent to the renter taking ownership, and Rent-Way is better off if the buyer pays $7.99 for 156 weeks instead of 78 weeks. The solution of the present-value equation

shows that the implicit annual interest rate is 230.57%.

7. The annual economic value added is $80,000 - 0.12($1,000,000) = -$40,000. If the annual economic value added is negative, then the market value is less than the cost of the assets ($1,000,000). Here, the economic value works out to be $1,000,000 - $40,000/0.12 = $666,666.

8. a. 306/47 = 6.5

b. r = 9064/47 = 19%

c. Earnings per share are 9064/5332 = 1.7, so that P/E =57.31/1.7 = 33.7

d. leverage = assets/equity = assets/(assets - debt) = assets/assets = 1

e. g = (1 - d) r = (1 - 0)0.19 = 19%

9. a. An increase in Microsoft’s profit rate should increase the price of its stock.

b. Because Microsoft shareholders’ required rate of return is likely to be less than its 19% profit rate, the price of Microsoft stock should fall.

c. An increase in interest rates would increase Microsoft shareholders’ required rate of return, lowering the price of Microsoft stock.

10. a. Since the number of shares has increased but earnings are unchanged, earnings per share declines.

b. Except for the taxes paid on the dividends, this is a nonevent: the price should fall by the size of the dividend. The mandatory taxes on the dividends should reduce the price of Microsoft stock even more.