# mid06-2a - University of Toronto Joseph L Rotman School of...

This preview shows pages 1–3. Sign up to view the full content.

University of Toronto Joseph L. Rotman School of Management MGT337Y Davydenko/Derrien/Florence/Lu/Nevard Feb. 13, 2007 MID-TERM EXAMINATION #2 SOLUTIONS Question 1 (a) EMH states that markets fully and immediately incorporate all available information. (b) The plot above is typical for firms announcing SEOs. In the presence of information asymmetry, managers know more than the market, and if they act in the interest of existing shareholders, they will only issue equity when their stock is overvalued. Therefore, an SEO announcement sends a negative signal to the market. It should be followed by a drop in the firm’s stock price, which is what we observe in the real world. (c) The plot is not consistent with semistrong efficiency. Semistrong market efficiency means that prices fully adjust to the new level as soon as the news of the SEO becomes public, which happens on the date of the public announcement t=0. In semistrong-efficient markets abnormal returns would be zero until date t=-1, but on date t=0 the price would jump to the new equilibrium level and stay constant afterwards. This would correspond to the light solid line in the graph below. The observed CAR shows overreaction at t=0, after which prices revert to the new equilibrium level at t=2. (d) The plot is not consistent with strong form efficiency. Strong form efficiency implies that markets adjust to the new level as soon as information becomes known to insiders. Assuming that the board meeting which took place at t=-3 is the first time insiders learned of the SEO, in strongly efficient markets the price would jump to the new level on that date, corresponding to the dotted line in the plot below. -9.00% -8.00% -7.00% -6.00% -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% -5 -4 -3 -2 -1 0 1 2 3 4 CAR strong efficiency semi-strong efficiency

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
2 Question 2 (a) V abc = \$20x20,000 shares = \$400,000. V abc = EBIT/R o R o = EBIT/V abc = 28,000/400,000 = 7% (b) We know from Modigliani-Miller Proposition I that in a world with no tax, V u =V l . Therefore, V xyz is equal to \$400,000. The value of XYZ’s equity is 400,000 – 100,000 = \$300,000. Using Modigliani-Miller Proposition II, we obtain R s = R o + B/S(R o – R b ) = 0.07 + 100,000/300,000(0.07 – 0.04) = 8% (c) The payoff from 10% of ABC’s equity is 0.1x28,000 = \$2,800. The cost of 10% of ABC’s equity is 0.10x400,000 = \$40,000.
This is the end of the preview. Sign up to access the rest of the document.

## This note was uploaded on 04/26/2011 for the course RSM 333 taught by Professor Sabrinabutti during the Spring '11 term at University of Toronto.

### Page1 / 4

mid06-2a - University of Toronto Joseph L Rotman School of...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online