Midterm Examination, BUS413

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1 Midterm Examination, BUS413 NAME: SFU Student number: Caution In accordance with the Academic Honesty Policy (T10.02), academic dishonesty in any form will not be tolerated. Prohibited acts include, but are not limited to, the following: speaking or communicating with other students who are writing examinations. copying from the work of other candidates or purposely exposing written papers to the view of other candidates. Instructions: For qualitative questions, point form is not an acceptable answer. For quantitative questions, an indication of how you arrived at particular numbers is required for the purpose of assigning part marks. This examination is composed of 7 questions and 7 pages (not equally marked for a total of 100). Please answer all questions on the examination. The examination period is 1 hour and 50 minutes. 1. Please provide short answers to the following questions (no more than 50 words for each question). a. (5 marks) Some economists argue that event studies that test for semi-strong market efficiency are problematic and may be misleading. What is the argument that stands behind this statement? b. (5 marks) Explain briefly the relation between the concept of arbitrage and market efficiency (EMH). a. The problem with event studies is that they are always a joint hypothesis testing of both the EMH and the asset pricing model used to measure abnormal return. Therefore, if we find an abnormal return it may due to (a) markets are not efficient or (b) the fact that we have the wrong asset pricing model for measuring risk. Deciding which of the two caused the result is problematic. b. EMH implies No Arbitrage, as all public information is incorporated in prices. However, the opposite is not necessarily true, i.e., No Arbitrage does not imply EMH. You could have a situation in which not all information is incorporated in prices (the semi strong EMH does not hold), but it does not mean that you can earn immediate riskless returns by selling some securities and buying others.

2 2. (15 marks) Suppose a soft drink producer and distributor is contemplating on becoming a public firm by going through the IPO process. After the IPO, the debt to equity of the firm is expected to be 50%. The risk free rate is 5% and the market risk premium is 6%. You have the following information on two major soft drink producers in the market. Equity Capitalization ($ million) Debt Value ($ million) Beta Coke $ 7200 $ Pepsi $ 7400 $ Calculate the required return of shareholders for the new IPO firm. Answer: W coke = 0.493, W pepsi =0.506 D/V coke = 0.208, D/V pepsi = B e (industry) = 0.493* *2 = 1.82 leverage (industry) = * *0.506 = B a (industry)=1.82*( )=1.243 IPO D/E=0.5 D=0.5E == E/V =E/1.5E=2/3 B a =1.243=B e *(2/3) B e = 1.243*3/2= Re = *6= %

3 3. (15 marks) Firms have different types of assets and there is no reason to think that they all have the same market risk. Consider Cisco Systems, an all equity financed firm, who in mid-2005 total equity capitalization was $110 billion, and whose shares had a beta of 2.2. Included in Cisco s assets was $16 billion in cash and risk-free securities. Suggest a procedure and provide a numerical calculation to find the beta of Cisco Systems business assets (i.e., the assets that are not cash and risk-free securities). Answer: Cisco s market value consists of business assets worth $94 billion plus $16 billion in cash. Because of the cash, the equity beta is low that its business risk a = e = 2.20 = enterprise + cash enterprise = 2.20 = Another way of looking at this, is to consider that cash is a negative amount of debt. = E D enterprise e + E + D E + D D = =

4 4. (20 marks) You operate a dance club that will generate $500,000 in its first year of operation. Most of the costs are variable and are 40% of revenues; however, you have a DJ on a fixed wage contract, whose wage is 75,000 in the first year and who is guaranteed an annual real increase in wage of 2%. The inflation rate is 3 % and revenues are expected to increase at 1% (nominal). The beta of the revenues is 1.2, the risk-free rate is 6%, and the market risk premium is 5%. The dance club will stop operating in 15 years, at which time it will be worthless. Calculate the NPV generated from the dance club. R revenues = 6%+1.2*5% = 12% Net growth= 1% Nominal increase in wage = (1.03*1.02)-1= 5.06% , , NPV = 1 1 = ) =3,148, ,898 = 1,522,358

5 5. (10 marks) Financial leverage leads to higher systematic risk (higher beta). However, suppose there is a possibility that a high levered firm (e.g., an airline company) defaults on its debt payment, which leads to bankruptcy. Isn t that idiosyncratic, firm-specific risk? Explain (max 40 words, or 4 lines). Answer: Bankruptcy defaults tend to occur during bad times. In good times, a leveraged firm would tend to perform well, while in bad times, a leveraged firm tends to do badly. Thus, there is a strong systematic component in bankruptcies, as they occur in downturns in the economy.

6 6. A computer plant costs $90 million to build and can produce computers that will generate cash flows with of $20 million in perpetuity if the line is successful, but only $5 million in perpetuity if it is unsuccessful. You believe that the probability of success is 40%. The project s risk is estimated at a discount rate of 15%. a. (5 marks) Would you build the plant? b. (10 marks) Suppose that in case of a failure the company can transform the plant to produce micro-processors at a cost of $5 million. Under this scenario, the following year (starting at year 2) the company will either generate $7 million or $14 million in perpetuity, each with probability of 50%. The cost of capital for this new plant is estimated at 12%. Now would you build the original plant? Answer a. NPV= -90M+(0.4*20M+0.6*5M)/0.15 = -90M M = M b. NPV=-90M+(0.4*20M)/0.15 +(0.6*0.5*14M+0.6*0.5*7M)/0.12/1.15 = 8.99M (or if add -5*0.6/1.15 = 6.37) Yes, I would build the plant. 20M 14M 7M

7 7. (15 marks) Suppose that ABC Inc. is having an election for 6 directors. You own 10% of the 210,000 shares outstanding. Mr. Kent owns 70%, and the various other shareholders own the remaining 20%. You are dissatisfied with the current directors and would like to elect yourself; however, Mr. Kent opposes your appointment. What is the percentage of votes (from the total of various other shareholders votes) that needs to vote with you in order that you be elected? Answer: Needed shares to be elected 210,000/ 7 = 30,000 You have 210,000 * 10% = 21,000 Needed 9,000 shares or 9,000/(42,000)=21.43 percentage of other shareholders stake.

Second Midterm Exam. Portfolio Beta Expected Return X 1 9% Y 2 10% Is there an arbitrage opportunity? If so, what exactly is it?

Second Midterm Exam. Portfolio Beta Expected Return X 1 9% Y 2 10% Is there an arbitrage opportunity? If so, what exactly is it? Second Midterm Exam Fall 018 Econ 180-367 Closed Book. Formula Sheet Provided. Calculators OK. Time Allowed: 1 Hour 15 minutes All Questions Carry Equal Marks 1. (15 points) You invest $100 in a bond that