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Midterm1Solutions

Midterm1Solutions - Economics 181 Corporate Finance...

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Economics 181: Corporate Finance Midterm #1’s Solutions Wadia Haddaji February 20, 2008 1
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(1)(30 points) (a)(7.5 points) Which of the following statements are true? I. The semi-strong form of the efficient-market hypothesis states that prices reflect all publicly available information. II. A potential test of the weak form of efficiency is to test whether technical analysts make abnormal profits. III. Tests have shown that there is almost perfect negative correlation between succes- sive price changes. A) I and II B) I and III C) II and III D) I, II and III E) less than two statements are true. Solution: (I) TRUE. This is actually the definition of the semi-strong form of efficiency. (II) TRUE. Since technical analysts use past prices to try to make profits, their perfor- mance is a good test of weak form efficiency. (III) FALSE. Tests have shown that markets are weak form efficient, i.e., market prices do not exhibit any correlation at all. (b)(7.5 points) (b)(7.5 points) According to Modigliani and Miller, which of the fol- lowing statements are true? I. In a world without taxes, the required return on equity is fixed. II. In a world with corporate taxes, the weighted average cost of capital decreases as the debt/value ratio increases. III. In a world without taxes, the weighted average cost of capital decreases as the equity/value ratio increases. 2
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A) I and II B) I and III C) II and III D) I, II and III E) less than two statements are true. Solution: (I) FALSE. It is the weighted average cost of capital that is fixed in a world without taxes; the cost of equity goes up as the debt-to-equity ratio is increased. (II) TRUE. With debt, the firm benefits from a tax shield that effectively reduces its (after-tax) cost of debt; this reduces the firms weighted average cost of capital. (III) FALSE. The weighted average cost of capital is fixed in a world without taxes.
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