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Problems involving stock valuation and investment strategy

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10) With regard to market efficiency, what is meant by the term "anomaly"? Give three examples of market anomalies and explain why each is considered to be an anomaly.

11) Suppose that all investors expect that interest rates for the 4 years will be as follows:

Year Forward Interest Rate
0(today) 5%
1 7%
2 9%
3 10%

What is the price of 3-year zero coupon bond with a par value of $1,000?

12) Mature Products Corporation produces goods that are very mature in their product life cycles. Mature Products Corporation is expected to pay a dividend in year 1 of $2.00, a dividend of $1.50 in year 2, and a dividend of $1.00 in year 3. After year 3, dividends are expected to decline at a rate of 1% per year. An appropriate required rate of return for the stock is 10%. The risk-free rate of return is 4% and the expected return on the market portfolio is 9%. The stock of Mature Products Corporation has a beta of 1.2. How much should the stock should be worth?

13) You buy one Xerox June 60 call contract and one June 60 put contract. The call premium is $5 and the put premium is $3.

a. What is your strategy called?
b. What is your maximum loss from this strategy?
c. At expiration, at what price(s) will you break even?

14) Discuss the differences in writing covered and naked calls. Are risks involved in the two strategies similar or different? Explain.

15) Aunt Gunda holds her portfolio 100% in U.S. securities. She tells you that she believes foreign investing can be extremely hazardous to her portfolio. She's not sure about the details, but has "heard some things". Discuss this idea with Aunt Gunda by listing three objections you have heard from your clients who have similar fears. Explain each of the objections is subject to faulty reasoning.

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10. A market anomaly is a price distortion in a financial market. It is considered anomalous because it contradicts the efficient market hypothesis. This states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Investors might be able to make abnormal profits by exploiting anomalies, which doesn't make sense in an efficient market.

Possible examples include:
? the Monday effect - in the period before 1987, Monday returns are significantly negative in all five US stock indexes
? the small-firm effect - average annual returns are consistently higher for small-firm portfolios, even when adjusted for risk by using the Capital Asset Pricing Model.
? the January effect - the small-firm effect occurs virtually entirely in January.
? the neglected-firm effect - small firms tend to be ignored by large institutional traders and stock analysts.
? the liquidity effect - investors demand a premium to invest in less-liquid stocks.
? book-to-market ratios - book-to-market ratios are used to find the value of a company by comparing the book value of a firm to its market value. Firms with higher book-to-market-value ratios have higher risk-adjusted returns, suggesting that they are underpriced.
? the reversal effect - stocks that have performed best in the recent past seem to reverse direction underperform the rest of the market, and vice versa.

These patterns return every year, allowing investors to profit from them. The market should adjust for this known information, but it doesn't.

11. A zero coupon bond is a bond that pays $1 at time T and no coupons prior to this period. These ...

Solution Summary

Various problems involving stock valuation and investment strategy.

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MBA - Week 5 Problems

FIN/554 class:

1. Brealey, Chapter 15, page 429, Challenge Question 3

Here is recent financial data on Pisa Construction.
Stock Price: $40 Market value of firm: $400,000
# of Shares: 10,000 Earnings per share: $4
Book net worth: $500,000 Return on Investment: 8%

Pisa has not performed spectacularly to date. However, it wishes to issue new shares to obtain $80,000 to finance expansion into a promising market. Pisa's financial advisers think a stock issue is a poor choice because, among other reasons, "sale of stock at a price below book value per share can only depress the stock price and decrease shareholders' wealth." To prove the point they construct the following example: "Suppose 2,000 new shares are issued at $40 and the proceeds are invested. (Neglect issue costs.) Suppose return on investment doesn't change. Then
Book net worth = $580,000
Total earnings = .08(580,000) = $46,400
Earnings per share = 46,400/12,000 = $3.87
Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.70"

Evaluate this argument with particular attention to the assumptions implicit in the numerical example.

2. Brealey, Chapter 15, page 429, Challenge Question 4

Do you think that there could be a shortage of finance for new ventures? Should the government help to provide such finance and, if so, how?

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