Finance 3320 Final Written Questions
What is meant when a mutual fund has a "load" fee? Are there any advantages/disadvantages for investing in a mutual fund with a load fee (relative to a "no-load" mutual fund)?
A load fee is fee that is charged by a mutual fund in order to invest your money in that fund. The fee is a percentage of the funds invested in the fund. These fees can be charged at the beginning (front-end load; when you initially invest) or at the end (back-end load; when you withdraw your funds), but the effect of the fee is the same...you lose the percentage of the load fee from your investment money. The evidence is that mutual funds cannot consistently earn abnormal returns. The way to maximize your returns on your investments in mutual funds is to minimize the fees that you pay. Since the load-fee funds cannot do any better on average than no-load funds, there is no advantage to paying a load fee. However, it is a big disadvantage to pay the load fee, as it increases your fees. You're better off with a no-load mutual fund.
Explain the different between a nominal cash flow and a real cash flow
A nominal CF is the actual CF you expect to receive, while the real CF represents the purchasing power of the money you expect to receive.
What is the difference between Rollover IRAs and traditional IRAs?
A traditional IRA is an account in which individuals can contribute to a retirement fund that is tax-advantaged (money is not taxes upon entry and no taxes on returns while money remains in the fund). Whereas a rollover IRA is an account into which one can transfer 401-k or 403-b retirement account funds upon leaving a company. You can contribute up to $5,500 per year (at the moment) into a traditional IRA, whereas the maximum limit to contribute to a rollover IRA is the amount in your company's 401-k or 403-b fund.
Explain the concept of an agency problem, and give an example of an agency problem.
An agency problem occurs when incentives for managers are not aligned with the incentives of owners. This occurs when managers receive a disproportionate share of the benefits of a decision (relative to its cost). One example would be the purchase of expensive art for the CEO's office. Shareholders pay for the art, but the CEO receives the benefit of having the art.
You overhear two friends talking about investment returns, prices, and risk in the cafeteria: Joel: "Prices in the market are set by investors who want returns. The higher the return, the more investors want that particular investment. And it is clear that the only way for investors to get more return is to take on more systematic risk. So if you are looking at two different investments that have the same expected CFs but one has more systematic risk than the other, investors will give a higher price to the investment that has more systematic risk because it will lead to higher returns." Ellie: "I'm not sure about that. Risk and return are linked... prices in the market reflect both the systematic risk and return of an investment. You cannot just focus on risk or return; they are linked. So the combinations of risk and return are set in the market so that the tradeoff is fair... more systematic risk leads to a fair amount of additional return. Thus, no combination of risk and return is better or worse than another. So we should see that, for two investments that have the same expected CFs but different levels of systematic risk, the prices of those two investments should be identical." They see that you're listening and they know that you're taking finance, so they ask you to settle their debate. Is either friend correct? If so, explain who is correct and why they are correct. If neither friend is correct, explain the correct interpretation and effect of risk and return on prices.
Both say things that are correct, but neither is completely correct... and neither has correctly described how risk and return affects prices. Joel is correct in that investors desire returns and that systematic risk leads to additional return. Ellie is correct in that risk and return are linked, and that the tradeoffs between risk and return in the market are fair and that no combination is necessarily better or worse than another given all investors. Some investors may have a preference of one risk/return combination than another, but there is no universal preference. But when valuing two investments with the same expected CFs, the one with the lowest risk (and thus the lowest systematic risk) will have the highest price. The return that we earn on an investment comes from the expected CFs of the investment and the price you pay for the investment. The expected CFs just depend on the "average" of the future CFs you expect to receive, whereas the risk of the investment depends on the volatility (think standard deviation) of the potential outcomes of the investment. The expected CF values do not convey the risk of the investment. So for two investments that have the same expected CFs, the only way for one to earn a higher return than another is through the initial investment (or price). The lower the price, the higher the return. So if you want to earn a higher return on an investment with a given set of CFs, you pay a lower price. An example would be the purchase of a stock. You want to buy Amazon stock... would you rather pay $10 per share or $50 per share? The CFs you receive from Amazon will not change depending on whether you pay $10 or $50 for the stock. But we'd all rather pay $10 for the stock, as our returns will be higher.
You are doing research about different investment strategies. You come across the following three research studies regarding strategies for investing. For each study, explain what the results of that particular study imply about the level of market efficiency in the stock market. c. Replicating Anomalies study: This study looked at every stock market efficiency anomaly that has been identified in past finance research. Then they applied cutting-edge statistical tests on these anomalies. They found that 80% of the "anomalies" disappeared using modern statistical analysis tools.
By using cutting-edge statistical methods, researchers were able to show that most anomalies that have been found in the past are not really anomalies at all! So this would be evidence in favor of market efficiency... both semi-strong form and weak form efficiency.
Casey, Chuck and Sarah are secret government spies on a stakeout. To pass the time, they talk about investing in stock markets. Sarah started to brag about how her stock investments have consistently beat the market, and how she is very skilled at picking winning stocks because she know what to look for in the financial statements of publicly-traded companies. Casey couldn't understand why Sarah went to all the trouble of reading the financial statements of firms, because he thought that picking winning stocks only required an analysis of past returns. Chuck, on the other hand, was skeptical of Sarah's skills at picking stocks. He said that, if she really had consistently beaten the market returns, she was either extremely lucky or she used insider information to make her high returns. Using the terminology that we used in class, state and explain how each person views the efficiency of financial markets.
Casey: Casey believes that markets are inefficient. If he believes that knowing past prices and returns can lead to abnormal returns, then he believes that this information isn't incorporated into current prices. Thus, markets are not even weak-form efficient... they are inefficient. Chuck: Chuck believes that markets are semi-strong form efficient. If he believes that the only way to beat the market is to have inside information (or be lucky), then markets must be semi-strong form efficient, as prices do not include private information. Sarah: Sarah believes that markets are weak-form efficient. Since she believes that using public information is enough to earn abnormal returns, it means that public information is not included in currently prices. So markets must only be weak form efficient.
At your next big family reunion, your uncle (who is a poet) comes to talk to you. He has heard that you just took a finance class, and wants to know what this whole "diversification" things is all about. He would like you to explain diversification to him in terms of what it is and why it is so beneficial. Explain the concept of diversification. In your answer, you should say what diversification is and how it benefits investors. (15 pts)
Diversification is the elimination of risk by combining investments together into a portfolio. Risk is eliminated through the offsetting movements of the investments within the portfolio. These offsetting movements occur due to the less-than-perfectly positively correlated investments within the portfolio, and lower correlation leads to more offsetting movements. These offsetting movements represent the unsystematic risk cancelling out. However, the systematic risk remains, as it is the risk that affects all investments in the portfolio. Investors do not like risk, so they can improve their portfolios through diversification, as it eliminates unwanted risk. Investors do like returns, and diversification does not affect the returns of the portfolio. So through diversification, investors keep what they like (returns) and eliminate what they don't like (risk).
What is an event study and how are they used in testing market efficiency? And what has been learned from event studies in relation to market efficiency?
Event studies use the response of the market to the release of new information to test how efficiently markets utilize information. Because market efficiency is based on how much information is incorporated into prices, the speed at which markets react to new information can indicate the type and level of market efficiency. Event studies have shown that new information is incorporated extremely quickly into market prices. The time between the release of new information and the full incorporation of that information into prices is typically less than the time it takes to log onto a computer and place a trade. This indicates that markets are (most likely) semi-strong form efficient.
Explain the evidence surrounding markets and semi-strong form efficiency. In your answer, be sure to describe how the evidence was obtained, as well as the investing implications from it.
Evidence of semi-strong form efficiency comes from two places: • Mutual funds primarily use fundamental analysis in their attempt to earn abnormal returns. But studies on mutual fund performance show that mutual funds do not earn abnormal returns on average, and that mutual fund performance is not persistent. • Event studies look at how quickly markets incorporate newly-available information into prices. Studies have shown that information gets incorporated into market prices extremely quickly... in a matter of seconds in some instances. This evidence is consistent with markets being semi-strong efficient... all publicly available information is reflected in the prices we see in markets. The implication of this is that using public information to make investment decisions will not lead to abnormal returns.
fundamental analysis
Fundamental analysis is the use of publicly available financial information (financial statements, analyst reports, etc.) to determine which stocks will perform well/poorly in the future.
What is fundamental analysis, and what is the evidence regarding its use and effectiveness?
Fundamental analysis is the use of publicly available information in order to earn abnormal returns on investments in financial markets. This public information includes past prices and returns, financial statements, news stories, analyst reports, and any other information that is available about the firm. The evidence on fundamental analysis is essentially evidence on semi-strong form efficiency. If fundamental analysis leads to abnormal returns, then markets are not semi-strong form efficient; if fundamental analysis does not lead to abnormal returns, then this would be consistent with semi-strong form market efficiency. There are two main ways to test semi-strong form efficiency. The first is to look at mutual fund performance. Most mutual funds use fundamental analysis to try to outperform the market; we can look to see if mutual funds earn abnormal returns. Studies overwhelming show that mutual funds do not earn abnormal returns. The other way to test semi-strong form efficiency is to use event studies. Event studies measure the speed at which markets react to new public information. If markets react quickly to new public information, then this is consistent with semi-strong form efficiency, as having access to public information won't help you earn abnormal returns. If markets react slowly, then you can earn abnormal returns on public information. Event studies show that markets incorporate information extremely quickly into prices... often within a matter of seconds. So this is also consistent with semi-strong form efficiency. Because markets appear to be semi-strong form efficient, then the use of fundamental analysis does not lead to abnormal returns. Anyone using fundamental analysis and earning abnormal returns is just lucky.
1. You are talking about your finance class with your father. You tell him that beta is a measure of systematic risk, which is the risk that affects all risky investments in the same direction. You also tell him that when CFs move together (like interest expense and tax shields), then they have the same risk (and thus, the same expected return). And you describe the concept to him that it is only systematic risk that leads to returns... you do not get compensated for unsystematic risk. His response: "Okay, I get it. Since systematic risk pushes everything in the same direction, and investments that move together have the same risk... then every investment has the same beta. And since beta is what leads to returns, then every investment has the same expected return." Critically analyze his response. If he is correct, explain why he is correct. If he is not correct, explain why he is incorrect and how you would explain things to him to correct his misunderstanding.
He isn't correct. Systematic risk... and therefore beta... isn't the same for every investment. It's true that systematic risk affects everything in the same direction. But because everything moves in the same direction, this does not necessarily mean that they move by the same amount. The examples we used in class were the grocery store and luxury cruise lines. Just because the market portfolio doubles in value doesn't mean that people buy twice as many groceries as before... or if the market portfolio loses half of its value, people don't buy half the food as before. Grocery stores have little systematic risk... ups and downs in the market do not affect grocery stores that much. Grocery stores are not very sensitive to systematic risk. But if the market portfolio doubles, people might buy more than double their purchases of luxury cruises... and if the market portfolio falls by half, they might reduce their luxury cruise purchases by more than half. We would expect luxury cruise companies to have lots of systematic risk... they will be highly sensitive to systematic risk. So systematic risk does affect everything in the same direction... but not necessarily by the same amount. And since the sensitivity to systematic risk is different for different investments, they will have different betas. And since they will have different betas, they will have different rates of return!
When determining the FCFs of a firm, why do we use NOPAT (Net Operating Profit After Taxes) instead of Earnings (or Net Income)? In other words, why not just use accounting earnings or net income, which have already been determined by the accountants, instead of hand-calculating NOPAT? Explain
In order to calculate Net Income, one needs to subtract interest expense. But interest expense is a financing CF. We do not include financing CFs when computing the FCF of the firm, as the FCFs represent the CF available to pay all investors (including debt investors). Thus, interest expense comes out of FCFs; it is not including in the calculation of FCF.
Explain the MM Theory of capital structure. Be specific in your answer, and be sure to explain how MM Theory helps us understand the importance of the financing decision.
MM Theory has two propositions. The first proposition states that capital structure doesn't affect firm value in a world with no taxes, no transaction or distress costs, fixed investment policy, and perfect information (we'll call this the MM world). The second proposition states that it is ONLY in the MM world that capital structure doesn't affect firm value. We don't live in the MM world, so we know that capital structure does affect the value of the firm. But MM Theory helps us understand the importance of the financing decision by identifying the channels by which capital structure does affect the value of the firm. For capital structure to affect firm value, it has 4 channels to do so: taxes, transaction and distress costs, investment policy, and imperfect information.
There have been some new developments in the world... Taxistan, one of the small, rarely heard-of states from the former Soviet Union, has decided to abolish all taxes in the country. The Taxistan government has also decreed that all managers must use and follow NPV at all times when making investment decisions. The government will subsidize all investment banking and bankruptcy costs for firms, and all information about any company must be freely available to all. a.What would MM say about the effect of capital structure on firm value in Taxistan with these policies?
MM says that if and only if there are no taxes, no transaction costs, perfect information, and fixed investment policy, then the capital structure will not affect firm value. In Taxistan, there are no taxes, no transaction costs, perfect information and fixed investment policy; thus, in this country, capital structure does not affect firm value.
The market portfolio is a theoretical idea, but we cannot actually use the true market portfolio because we cannot observe and measure the returns to every risky investment. But we need the market portfolio returns to compute betas. Explain what one should use as the "market portfolio." You do not actually need to state an actual substitute for the market portfolio, but you do need to explain what must be true about the substitute for it to be an appropriate choice for the market portfolio.
Many people use the S&P 500 as the market portfolio... but a lot of other people use other measures for the S&P 500. So what should be true about what we use as a substitute for the market portfolio? The market portfolio contains only systematic risk; another way to say this is that it contains no unsystematic risk. Therefore, what type of portfolio would contain no unsystematic risk? A portfolio that is very well-diversified. This would be a portfolio that is invested in many securities, across many industries (and geographic regions) and that represents a large portion of economic activity. And for it to work as a substitute for the market portfolio, it has to be something that is easy to track (so that we can calculate the returns of this portfolio). The S&P 500 certainly fits this description, but so would many other portfolios.
At your next big family reunion, your uncle (who is a poet) comes to talk to you. He has heard that you just took a finance class, and wants to learn about picking winners in the stock market and "beating the market." Explain market efficiency to him, give him your opinion on the level of market efficiency in U.S. markets (and the evidence to back up your opinion), and your advice regarding how to earn abnormal returns.
Market efficiency is the degree to which prices in financial markets reflect available information. The more information that is incorporated into prices, the more efficient that market becomes. The evidence suggests that markets in the U.S. are both weak and semi-strong form efficient. In weak form efficient markets, prices incorporate information about past prices and returns, while in semi-strong form efficient markets, prices incorporate all publicly available information. Studies have shown that markets are very fast to incorporate new information into prices; often, the new information is incorporated within seconds of announcement. Other evidence includes the failure of fundamental and technical analysis (two methods which try to use publicly-available information to pick investments) to earn abnormal returns (a fancy way of saying that they do not beat the market). We also know that markets are not strong form efficient... prices do not include all public and private information. Studies have shown that insiders consistently earn abnormal returns on their trades. Thus, private information is not reflected in the prices we see in the markets. If you want to consistently earn abnormal returns in U.S. markets, you need to either be very lucky or use insider information. And since insider trading is illegal in the U.S., I don't recommend that approach!
6. Your colleague (who went to Texas A&M) is talking to you about risk and return. You start talking to him about how, when investors receive extra return for holding risk, it is only the systematic risk that matters. You say that unsystematic risk does not result in extra return. Your colleague replies: "Yup... that's what you get for having Obama in the White House. He nominates a 'risk/return' guru who oversees all of the different markets and regulates what type of risk gets rewarded with return. When his presidential term is up... and assuming the country doesn't elect someone similar to replace him... soon we'll all be able to earn extra return for holding onto unsystematic risk." Is your friend correct? If so, explain why. If not, explain how it is that unsystematic risk does not get rewarded with extra return.
No... we cannot blame Obama for this one! There is no guru that ensures that only systematic risk is compensated with return. The reason that unsystematic risk is uncompensated by the market is because diversified investors set prices. When an investment is riskier for an investor, the investor values it less (as investors don't like risk)... and thus the price falls. So for any investment, the investor who sees the least risk with that investment will value it the most! Every investment has both systematic and unsystematic risk. Well-diversified investors have many investments in their portfolios; the unsystematic risk of any investment will be eliminated through the offsetting movements of other investments within the portfolio. These investors only "see" the systematic risk of each investment. On the other hand, undiversified investors do not have as many investments in their portfolio and thus cannot fully eliminate all of the unsystematic risk of each investment. These investors "see" both the systematic and unsystematic risk of an investment. In free markets, the highest price wins. And who will be setting the highest price? It will be the investor who sees the least risk and thus values the investment the most. This is the diversified investor who only needs to be compensated for the systematic risk. No guru needed!
What is meant by "scale expansion of the firm"? And explain why this concept is important when determining the discount rate for an investment
Scale expansion is just a firm expanding its existing business in a way that doesn't alter the risk of the overall business. It's the firm expanding by "doing what it is already doing". This is an important concept when determining the discount rate of an investment because, in order to determine the discount rate for an investment, we need to know the risk of the investment itself! But the only thing that we can measure is the risk of the company (through the estimation of beta using stock returns). So we can only know the risk of the investment if it is the same as the risk of the company... and the only way for the investment to have the same risk as the company itself is for the investment to be exactly like what the company is already doing.
You know that the evidence suggests that financial markets are semi-strong form efficient. But you know that not everyone agrees on this issue, and you want to gauge the opinions of other people. For each person below, state (in terms of the levels of market efficiency discussed in class) each person's view of market efficiency, and explain your reasoning. (3 pts each) a. Your friendly Starbucks barista: "I think that it's pretty hard to earn higher returns than the market, unless you have some inside information."
Semi-strong efficiency: the barista believes that all public information is already incorporated into the stock price. However, abnormal returns can be made with private information, so this does not describe strong form efficiency.
Compare and contrast 401-k plans and traditional IRAs.
Similarities between 401-k plans and traditional IRAs include: • Both are investment vehicles that encourage saving for retirement • Both allow for investment in stocks, bonds, mutual funds, etc. • Both allow for investment of pre-tax dollars (i.e. investors avoid taxes today on what they save) • Both investments grow tax-free. • Both investments are taxed once money is removed from accounts during retirement • Investors of both would incur penalties if they try to withdraw these funds prior to retirement age (except for a very few circumstances) Differences include: • 401-k plans are through one's employer, while IRAs can be set up by individuals • Participation in 401-k is limited to those with that particular benefit from their employer, while anyone can open an IRA • Employers often match 401-k contributions, while IRA contributions are not matched by anyone • The annual maximum contribution is different for each
You know that the evidence suggests that financial markets are semi-strong form efficient. But you know that not everyone agrees on this issue, and you want to gauge the opinions of other people. For each person below, state (in terms of the levels of market efficiency discussed in class) each person's view of market efficiency, and explain your reasoning. c.Your uncle: "I find it hard to believe that anyone could consistently beat the market, even if they had insider knowledge."
Strong form efficiency: all information (including insider or private information) is already incorporated into the stock price. Even if you had inside information, you could not earn an abnormal return with that information.
Systematic risk is the risk that cannot be diversified away. Why is it that we cannot eliminate systematic risk by combining investments into a portfolio?
Systematic risk is the risk that affects all investments in the same direction, whereas diversification is the elimination of risk through offsetting movements of returns within the portfolio. If systematic risk moves all investments in the same direction, then it cannot cause offsetting movements and thus cannot be eliminated.
technical analysis
Technical analysis is the use of past prices and returns to determine which stocks will do well (or poorly) in the future.
Compare and contrast technical analysis and fundamental analysis. And given what is known about market efficiency, which method of analysis works better?
Technical analysis is the use of past prices and returns to determine which stocks will do well (or poorly) in the future. Fundamental analysis is the use of publicly available financial information (financial statements, analyst reports, etc.) to determine which stocks will perform well/poorly in the future. Both are methods of trying to use information to pick winner/loser stocks and earn returns above the market returns. However, technical analysis depends on looking past prices for this information, while fundamental analysis depends on publicly available information. Given that markets are semi-strong form efficient, we know that all information about past prices AND publicly available information are already incorporated into the current stock price. In other words, having that information will not enable you to pick winners/losers in the stock market. Thus, neither method of analysis has been shown to work at all. Neither is better.
There have been some new developments in the world... Taxistan, one of the small, rarely heard-of states from the former Soviet Union, has decided to abolish all taxes in the country. The Taxistan government has also decreed that all managers must use and follow NPV at all times when making investment decisions. The government will subsidize all investment banking and bankruptcy costs for firms, and all information about any company must be freely available to all. b.What would happen to the market values of firms in Taxistan upon the announcement of these policies? And which types of firms would be more greatly affected... firms currently with high levels of debt or firms currently with low levels of debt?
The CFs of a firm have 3 claims... that of debt, equity, and the government (through taxes). So, if there are no taxes in Taxistan, then there is no government claim on the CFs of the firm, and the value of all firms will increase. We know that adding debt to the capital structure can reduce the taxes that companies pay; so (all other things being equal) firms that have lower debt end up paying more taxes. So, firms with lower debt will have the greatest increases in value once these policies are in effect.
Explain the intuition behind the WACC equation. In your answer, be sure to comment separately on the reason for the (1-t) term in the equation.
The WACC equation solves for the return on assets given the weights of debt and equity capital, the expected returns of each type of capital, and the tax shield generated by the interest expense on the debt. The intuition is that, for any scale expansion investment that the firm makes, it needs to make its shareholders happy. How do managers do this? By paying the shareholders their expected return on equity investment. But before shareholders get paid, debtholders have to be paid first! So in order to make shareholders happy, both debt and equity investors must receive their expected returns. The WACC is the result of this. The (1-t) term is for the tax shields on the debt. Essentially, the government partially subsidizes debt financing by granting firms a deduction on their interest expense. So when the company pays 5% on their debt to their debt investors, the government gives some of this expense back to the firm in the form of tax savings. So the (1-t) term is there to account for the tax shields that debt provides to the firm.
Describe three benefits and one negative to using a 401-k plan for saving for retirement.
The benefits of using a 401-k are: • Investments are made pre-tax (before you've paid taxes on them. • Investments grow tax-free while invested in the account. • Your employer often matches some of your investments, which effectively is an instantaneous 100% return on your investment. The negative is that you cannot access this money until you reach age 59½ without paying a penalty.
What is the characteristic line for a firm?
The characteristic line is the result of the regression analysis of an investment's returns on the market portfolio's returns. It is the best fit line for the return data used to run the regression. The slope of this line is beta, which is our measure of systematic risk.
What is the correct discount rate to use to value the interest tax shields of most firms? And in your answer, explain the logic for using this discount rate.
The correct discount rate is the return on debt (or rd). The logic is this: the main risk of most firm's debt is the interest expense on the debt (since most principal payments are paid by refinancing the debt). And the tax shields are only received when the firm pays interest expense. So the CFs to debt holders and the CFs of the tax shields move together. And since they move together, they have the same risk. And since they have the same risk, they have the same required rate of return!
What is the difference between an index fund and an actively-managed mutual fund? Is there any reason to believe that one might be a better investment than the other?
The difference is that the index fund has a pre-specified buy-and-hold investment objective, while the actively-managed fund is buying and selling stocks in order to achieve greater returns and beat the market. There is evidence that suggests that mutual fund managers cannot consistently beat the market returns, and the fees for index funds are lower than those for actively-managed funds. Therefore, this suggests that index funds might be a better investment than actively managed mutual funds because you earn similar pre-fee returns and get better post-fee returns.
Explain the evidence surrounding markets and strong market efficiency. In your answer, be sure to describe how the evidence was obtained, as well as the legal and investing implications from it.
The evidence regarding strong market efficiency involves looking at whether using private (or inside) information can lead to abnormal returns. Insiders of the firm (the executives and board of directors) must disclose to the SEC when they buy or sell stock in the company. From this information, we can determine whether insiders earn abnormal returns. And they do; insiders, on average, sell stock before its price falls and purchase stock before its price rises. Since private information can be used to earn abnormal returns, private information is not reflected in the market price of the stock... and thus, markets are not strong form efficient. The legal implication is that insider trading is illegal in the United States. But the investing implication is that you can earn abnormal returns if you have private information.
What big assumption is made when we convert from equity beta to asset beta using the formulas on the formula sheet? Is this assumption valid? And is the assumption reasonable? Be specific in your explanation, and be sure to answer each of these questions.
The real equation for the asset beta is: β_a=β_d ((D(1-t))/(D(1-t)+E))+β_e (E/(D(1-t)+E)) This comes from two facts: that the assets of the firm are equal to the debt and equity claims of the firm (and thus we can think of the assets as a portfolio of debt and equity), and the fact that a portfolio's beta is just a weighted average of the betas of each investment within the portfolio. Adding in the tax effects of debt, and this is the true equation for calculating the asset beta. The big assumption is that we assume that the beta of the debt is zero. With this assumption, the equation simplifies to: β_a=β_e (E/(D(1-t)+E)) This assumption is not valid (or true) as this assumption means that the debt is risk-free, and we know that the debt of a company is not risk-free. Compare the yields to maturity on corporate debt to U.S. government debt (which we consider to be risk-free) to convince yourself that corporate debt is not risk-free. So this assumption isn't valid. However, it is a reasonable assumption. When betas are calculated on corporate debt (using returns on bonds in the regression analysis), we find that (for most firms) the beta of debt is very close to zero. This is to be expected, as the risk associated with the debt of most companies is firm-specific... and thus unsystematic. So assuming that the risk of the debt for most healthy firms is a reasonable assumption to make.
What is the security market line?
The security market line is the graphical representation of the CAPM. It is a line that represents the returns of an investment given its systematic risk (or beta). It has a y-intercept of the risk-free rate, and a slope of ((R_m-r_f ) ̅ ), or the expected risk premium per unit of beta.
If standard deviation is measure of total risk while beta is a measure of systematic risk, then explain how a stock can have total risk of 0.22 but systematic risk of 1.2?
The two measures of risk are different in the units that they measure. Standard deviation measures in units of percent... a standard deviation of 0.3 is the same as 30%. Beta is scaled by the market's standard deviation... thus, beta is measured relative to the market. It is not in units of percent.
Define the three types of market efficiency. Also describe a trading strategy that yields abnormal returns for each type of market efficiency. Explain your reasonin
There are three forms of market efficiency. Weak form efficiency is when all information about past stock prices is reflected in the current stock price. To earn abnormal returns in weak form efficient markets, one just needs to trade on other public information or private information, as this information would not be incorporated into the stock price. Semi-strong form efficiency is when all public information is reflected in the current stock price. This includes past stock prices and any publicly available information (such as financial statements, analyst reports, etc). To earn abnormal returns in semi-strong form efficient markets, one needs to trade private information, as this information would not be incorporated into the stock price. Strong form efficiency is when all information (both public and private) is reflected in the current stock price. To earn abnormal returns in strong form efficient markets... well, one cannot consistently earn abnormal returns in this case without luck, as there is no information that you can obtain that hasn't already be incorporated into the stock price.
You work at TLOU and just got out of a meeting with the CEO in which she told you of her plans for the capital structure. In the meeting, she said that she decided last week about letting the existing debt mature in 5 years without replacing it with new debt, but that she doesn't expect to make a formal announcement about this plan. What does the research evidence suggest about your abilities to now earn abnormal returns when investing in TLOU? And does your ability to earn abnormal returns depend on where you live and invest?
This is information that is not available to everyone... this would be private (or insider) information. So what does the evidence say about insider information? We have clear evidence that those with private information can earn abnormal returns. Markets are not strong-form efficient. So you can earn abnormal returns with this information. In this case, you would expect that the value of the stock will fall when the rest of the world learns that your firm will not perpetuate the debt forever... thus, you can sell now while the price still reflects the perpetual tax shields! But this does depend on where you live and invest, as trading on this information is illegal in some countries (including the U.S.). If you invest in U.S. markets, then you could only earn abnormal returns through the illegal trading on insider information... the potential for jail time and civil penalties may (hopefully) deter you from trying to profit off of this information at all! But if you live and invest in a country that does not make insider trading illegal (such as the U.K.), then you have no deterrent to investing... you can make abnormal returns on your insider information until the announcement of the new plan for debt.
You know that the evidence suggests that financial markets are semi-strong form efficient. But you know that not everyone agrees on this issue, and you want to gauge the opinions of other people. For each person below, state (in terms of the levels of market efficiency discussed in class) each person's view of market efficiency, and explain your reasoning. d. Your high school buddy: "I think that I can look at the patterns of historical stock prices to determine where prices are going in the future. Since I know where prices are going in the future, I can earn higher returns than the market."
This person believes that markets are inefficient. Weak form efficiency states that current prices incorporate all information about past prices, but your buddy thinks that abnormal returns can be made just by analyzing past prices. Thus, this person does not believe that markets are efficient.
You are doing research about different investment strategies. You come across the following three research studies regarding strategies for investing. For each study, explain what the results of that particular study imply about the level of market efficiency in the stock market. a.Momentum study: This research study showed that, by investing in the stocks had the highest returns over the previous 6 months, one could earn abnormal returns in the next 6 months.
This shows that information about past returns can be used to earn abnormal returns going forward. This evidence would be inconsistent with weak-form efficient markets. So this would be evidence that markets are inefficient.
You are doing research about different investment strategies. You come across the following three research studies regarding strategies for investing. For each study, explain what the results of that particular study imply about the level of market efficiency in the stock market. b.Post Earnings Announcement Drift: This research study showed, by investing in stocks that had the highest earnings in a quarter, one could earn abnormal returns in the next quarter
This shows that information contained in financial statements, aggregated across all firms, can be used to earn abnormal returns. This would be inconsistent with semi-strong form efficiency, where this information would already be reflected in market prices. So this would be evidence against semi-strong form efficiency (and for either weak form or inefficient markets.
Explain how Microsoft's beta is measured. Be as specific as possible.
To calculate Microsoft's beta, we need to measure the past stock returns of Microsoft. Then we determine the relationship between the returns of Microsoft and the market portfolio (to get the systematic risk). For this, we do a regression analysis. We need to pick what will represent the market portfolio (usually, the S&P 500). The slope of the regression is the beta
You know that the evidence suggests that financial markets are semi-strong form efficient. But you know that not everyone agrees on this issue, and you want to gauge the opinions of other people. For each person below, state (in terms of the levels of market efficiency discussed in class) each person's view of market efficiency, and explain your reasoning. b.Your stock broker: "I go through all of the financial statements, analyst reports and business news that pertain to public companies. Because of this, I can earn higher returns than the market."
Weak form efficiency: the broker believes that abnormal returns can be made by analyzing public information, so the broker does not believe that markets are semi-strong form efficient.
What assumption do we make when we use the time series approach to estimating expected returns for an investment?
When using time-series statistics to estimate expected returns for an investment, we are using the average return over past periods to estimate future returns. In order to do this, we make the assumption that the distribution of past returns is essentially the same as the distribution of future returns. Note that we are NOT assuming the past returns will be the same as future returns... only that the distribution of returns will be the same.
Is it possible to combine two risky investments into a portfolio and have the resulting portfolio be risk-free?
Yes, it is possible to combine two risky investments and have a portfolio that is risk-free. It requires two investments that are perfectly negatively correlated with each other. This means that the correlation between them is -1. When correlation is -1, the upward movements of one investment are completed offset by the downward movements of the other. The combination of these two investments results in no movement of the portfolio. The graph below shows this. As one goes up, the other falls... and the combined movement is zero.
Is it possible for one portfolio to have a beta of 1.25 and a standard deviation of 26% while another portfolio has a beta of 1.52 and a standard deviation of 21% (i.e.: can one portfolio have a higher standard deviation but lower beta than another portfolio)?
Yes, it is possible, but only when the portfolios are not well diversified. When a portfolio is well-diversified, then the unsystematic risk has been essentially eliminated... leaving only systematic risk. So the total risk of a well-diversified portfolio contains only systematic risk. In this case, the total risk should be proportional to the systematic risk, and the situation above should not be possible. But if at least one of the portfolios is not well-diversified, then the total risk of the portfolio should contain unsystematic risk. So while the portfolio might have low systematic risk, the unsystematic risk could cause the total risk of the portfolio to be large.
7. Earl and Randy Hickey are brothers who won the lottery and have decided to go into business together. They are interested in oil prospecting, which is the business of looking for oil and drilling oil wells. Most oil prospectors find oil in only 1 out of every 5 wells that they drill, but Earl and Randy feel that their good karma will enable them to find oil in 1 out of every 2 wells that they drill. Regardless of their karma, they have signed contracts to sell any oil that they find to Exxon oil refineries at set prices. Thus, the only risk of their potential venture is whether they find oil and how much oil they find. They hire you to evaluate whether this venture is a good investment for them to make. Do you have enough information to calculate a discount rate for them? If so, explain why and calculate the discount rate.
Yes, there is enough information to calculate a discount rate. When determining a discount rate, we are concerned with the riskiness of the cash flows that result from the project. But we are not concerned with total risk... only systematic risk. Thus, to determine a discount rate, we need to know the amount of systematic risk, or beta, of the CFs from the investment. Once we have beta for the investment, we can plug the beta into the CAPM and get a discount rate. Now let's look at this investment. It is risky... there is a chance that no oil will be found, and who knows how much oil they would find if they are successful. However, because they have locked in a price for any oil that they find, the ONLY risk of the investment is whether they find oil and how much they find. Both of these risks are company or project-specific... market-wide economic shocks will not affect Earl's ability to find the oil or the amount that they eventually find. Therefore, there is no systematic risk in this investment... and beta is zero. Therefore, the correct discount rate for Earl and Randy to use is the risk-free rate, or 4%.
Earl and Randy Hickey are brothers who won the lottery and have decided to go into business together. They are interested in oil prospecting, which is the business of looking for oil and drilling oil wells. Most oil prospectors find oil in only 1 out of every 5 wells that they drill, but Earl and Randy feel that their good karma will enable them to find oil in 1 out of every 2 wells that they drill. Regardless of their karma, they have signed contracts to sell any oil that they find to Exxon oil refineries at set prices. Thus, the only risk of their potential venture is whether they find oil and how much oil they find. They hire you to evaluate whether this venture is a good investment for them to make. Do you have enough information to calculate a discount rate for them? If so, explain why and calculate the discount rate. If not, explain why not. (10 pts)
Yes, there is enough information to calculate a discount rate. When determining a discount rate, we are concerned with the riskiness of the cash flows that result from the project. But we are not concerned with total risk... only systematic risk. Thus, to determine a discount rate, we need to know the amount of systematic risk, or beta, of the CFs from the investment. Once we have beta for the investment, we can plug the beta into the CAPM and get a discount rate. Now let's look at this investment. It is risky... there is a chance that no oil will be found, and who knows how much oil they would find if they are successful. However, because they have locked in a price for any oil that they find, the ONLY risk of the investment is whether they find oil and how much they find. Both of these risks are company or project-specific... market-wide economic shocks will not affect Earl's ability to find the oil or the amount that they eventually find. Therefore, there is no systematic risk in this investment... and beta is zero. Therefore, the correct discount rate for Earl and Randy to use is the risk-free rate, or 4%.
2. The management of a small, independent sporting shoe manufacturing company wants to calculate a discount rate for its various shoe manufacturing projects and has hired you as a consultant. Since they are a privately-held company, you suggest that they use Nike's equity beta and capital structure to determine the discount rate for their project. Their response is: "We are way too small to compare to a large firm like Nike. We think that the appropriate firm to use is Hammock Enterprises, Inc (they make hammocks). They are very similar in size to our firm, and their hammock factory is just down the street from ours. And we sell to many of the same sporting goods stores as Hammock Enterprises." Who is correct, and why?
You are correct. According to the market portfolio, size is a risk factor should be something that can be diversified away... the only risk is that risk which is related to the sensitivity of the firm to the overall market. You want to know how much systematic risk is in the business of producing and selling shoes, which is what Nike does. Hammocks, while sold in the same stores, are not the same products, and thus would probably not be the same risk (and certainly shouldn't be assumed to have the same risk) as manufacturing shoes.
At your first job, a colleague and you are discussing the financing decisions of your company. Your colleague says: "MM Theory tells us that having debt in the capital structure increases the value of the firm through the tax benefits of debt. Specifically, the firm lowers its profitability (and thus its taxes) by deducting interest expense from its pre-tax profits. Our goal, as managers of the firm, is to maximize the value of the firm. Thus, we should take on as much debt as possible... even if it means being 100% financed with debt." Is your colleague correct?
Your colleague is partially correct. It is correct that the MM Theory states taxes lead to increases in the value of the firm through the tax shields created by interest expense. Interest expense doesn't lower the FCFs of a company (because interest expense comes out of FCFs), but taxes are lowered as pre-tax profitability is reduced by the interest expense. The reduction in taxes is an increase in the FCFs of the firm, and thus increase the value of the firm. However, this does not mean that taking on as much debt as possible will maximize the value of the firm. MM Theory discusses 4 channels through which capital structure affects the value of the firm: taxes, transaction and distress costs, investment policy, and imperfect information. As debt goes up, the other channels may affect the value of the firm in a negative way. For example, we discussed how when debt goes up, the PV of distress costs goes up. At some high levels of debt, the loss of value due to distress costs is greater than the increase in value from tax shields. Therefore, it does not maximize the value of the firm to take on as much debt as possible.
