Problem Set 7 Solution Key Finance Economics Prof Farshid Mojaver Part A Capital Budgeting 1 Jack s Construction Co has 80 000 bonds outstanding that are selling at par value Bonds with similar characteristics are yielding 8 5 The company also has 4 million shares of common stock outstanding The stock has a beta of 1 1 and sells for 40 a share The U S Treasury bill is yielding 4 and the market risk premium is 8 Jack s tax rate is 35 What is Jack s weighted average cost of capital Answer Re 04 1 1 08 128 Debt 80 000 1 000 80m Common 4m 40 160m Total 80m 160m 240m 2 Assuming the CAPM or one factor model holds what is the cost of equity for a firm if the firm s equity has a beta of 1 2 the risk free rate of return is 2 the expected return on the market is 9 and the return to the company s debt is 7 Answer Rs Rf Rm Rf 02 1 2 09 02 104 10 4 3 On line Text Co has four new text publishing products that it must decide on publishing to expand its services The firm s WACC has been 17 The projects are of equal risk s of 1 6 The risk free rate is 7 and the market rate is expected to be 12 The projects are expected to earn as follows What projects should be selected and why Answer Required Rate of Return 07 1 6 12 07 07 1 6 05 07 08 15 15 Projects X Y 15 Accept NPV 0 Project Z 15 Indifferent NPV 0 Project W 15 Reject WACC rate of 17 is irrelevant The risk of the projects must be different than risk of company 1 Part B Efficiency Market Hypothesis 1 Explain the three forms of efficient market hypothesis Include in your discussion the information sets involved in each form and the relationships across information sets and across forms of market efficiency Also discuss the implications for the various forms of market efficiency for the various types of securities analysts Answer The weak form of the efficient markets hypothesis EMH states that stock prices immediately reflect market data Market data refers to stock prices and trading volume Technicians attempt to predict future stock prices based on historic stock price movements Thus if the weak form of the EMH holds the work of the technician is of no value The semistrong form of the EMH states that stock prices include all public information This public information includes market data and all other publicly available information such as financial statements and all information reported in the press relevant to the firm Thus market information is a subset of all public information As a result if the semistrong form of the EMH holds the weak form must hold also If the semistrong form holds then the fundamentalist who attempts to identify undervalued securities by analyzing public information is unlikely to do so consistently over time In fact the work of the fundamentalist may make the markets even more efficient The strong form of the EMH states that all information public and private is immediately reflected in stock prices Public information is a subset of all information thus if the strong form of the EMH holds the semistrong form must hold also The strong form of EMH states that even with inside legal or illegal information one cannot expect to outperform the market consistently over time Studies have shown the weak form to hold when transactions costs are considered Studies have shown the semistrong form to hold in general although some anomalies have been observed Studies have shown that some insiders specialists major shareholders major corporate officers do outperform the market 2 What is an event study It is a test of what form of market efficiency Discuss the process of conducting an event study including the best variable s to observe as tests of market efficiency Answer A event study is an empirical test which allows the researcher to assess the impact of a particular event on a firm s stock price To do so one often uses the index model and estimates et the residual term which measures the firm specific component of the stock s return This variable is the difference between the return the stock would ordinarily earn for a given level of market performance and the actual rate of return on the stock This measure is often referred to as the abnormal return of the stock However it is very difficult to identify the exact point in time that an event becomes public information thus the better measure is the cumulative abnormal return which is the sum of abnormal returns over a period of time a 2 window around the event date This technique may be used to study the effect of any public event on a firm s stock price thus this technique is a test of the semistrong form of the EMH 3 Discuss the small firm effect the neglected firm effect and the January effect the tax effect and how the four effects may be related Answer Studies have shown that small firms earn a risk adjusted rate of return greater than that of larger firms Additional studies have shown that firms that are not followed by analysts neglected firms also have a risk adjusted return greater than that of larger firms However the neglected firms tend to be small firms thus the neglected firm effect may be a manifestation of the small firm effect Finally studies have shown that returns in January tend to be higher than in other months of the year This effect has been shown to persist consistently over the years However the January effect may be the tax effect as investors may have sold stocks with losses in December for tax purposes and reinvested in January Small firms and neglected firms would tend to be more affected by this increased buying than larger firms as small firms tend to sell for lower prices The purpose of this question is to reinforce the interrelationships that effects may not always be independent and thus readily identifiable Also these effects are widely discussed in the financial press and the January effect appears to be quite persistent 4 Why might the degree of market efficiency differ across various markets State three reasons why this might occur and explain each reason briefly Answer 1 Market efficiency depends on information being essentially free and costless to market participants In the U S markets this is the case to a large extent The U S markets are well developed and professional analysts often follow securities Information is available on television in the press and on the Internet The opposite may be true in other markets such as those of developing countries where there are fewer or no analysts and few market participants with these resources