Financial_Economics_Midterm_Exam_Spring_2019_A.pdf -...

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Financial Economics Midterm (35% of Grade) Part A: True/False and Short Answer (3 pts each) 1. What are the key advantages of the separation of ownership from control (SOC)? SOC allows for the firm’s management to make decisions on a day-to-day basis without consulting owners—the shareholders. Management should maximize the value of the corporation’s shares (or price per share). Investors can choose to hold a diversified portfolio of shares in a large number of firms to maximize utility without having to manage each firm directly. 2. How do agency costs arise from SOC? SOC means that shareholders delegate their authority to management so shareholders do not control management directly on the day-to-day operations of the firm. Thus, management’s objectives do not likely align perfectly with that of shareholders. There is an agency problem with shareholders as principals and management as agents. Managers maximize their utility subject to the constraints and incentives established by the shareholders through laws and the shareholder representatives—the board of directors. To the extent that management does not maximize the firm’s value, such as by taking perks not agreed to by shareholders, agency costs arise as the difference in the maximum firm value less the costs of the perks (direct or indirect). 3. True/False and explain: A corporation’s objective function is to maximize profit. [ False: A corporation’s objective function is to maximize the value of the firm (value per share). 4. True/False and explain: A US corporate bond of maturity T will have a greater yield to maturity than the equivalent maturity UST bond. True: A corporate bond carries default risk. A UST bond carries none. There the corporate bond YTM requires a risk premium relative to the UST bond. They both have the same maturity, hence the same interest rate risk. 5. Suppose that an investment project has the following cash flows: Year 0 1 2 3 4 5 6 7 8 CF -10K 5K -2K 5K 5K -2K 5K 5K 1K Why would you have potential concern using the IRR rule to evaluate the project rather than NPV? There will be 3 IRRs given the changes in sign of the cash flows. Which one should you use to compare to the discount rate? You might blindly not even know that there would be more than one IRR. The NPV approach always gives you the correct answer.
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6. Suppose that Homer Inc. has a beta = .5 but its expected return is below the Security Market Line in the CAPM.
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