HW7s - Problem Set 7 Solution Key Finance Economics Prof....

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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 R e = .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 + β (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, ßs 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
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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
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HW7s - Problem Set 7 Solution Key Finance Economics Prof....

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