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CHAPTER 14 B-
CHAPTER 14
CORPORATE FINANCING DECISIONS
AND EFFICIENT CAPITAL MARKETS
Answers to Concepts Review and Critical Thinking Questions
1. To create value, firms should accept financing proposals with positive net present values. Firms can
create valuable financing opportunities in three ways: 1) Fool investors. A firm can issue a complex
security to receive more than the fair market value. Financial managers attempt to package securities
to receive the greatest value. 2) Reduce costs or increase subsidies. A firm can package securities to
2. The three forms of the efficient markets hypothesis are: 1) Weak form. Market prices reflect
information contained in historical prices. Investors are unable to earn abnormal returns using
historical prices to predict future price movements. 2) Semistrong form. In addition to historical
3. a. False. Market efficiency implies that prices reflect all available information, but it does not
imply certain knowledge. Many pieces of information that are available and reflected in prices
b. True. Market efficiency exists when prices reflect all available information. To be efficient in
the weak form, the market must incorporate all historical data into prices. Under the semistrong
c. False. Market efficiency implies that market participants are rational. Rational people will
d. False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate
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CHAPTER 14 B-
e. True. Competition among investors results in the rapid transmission of new market information.
4. On average, the only return that is earned is the required return—investors buy assets with returns in
excess of the required return (positive NPV), bidding up the price and thus causing the return to fall
6. Yes, historical information is also public information; weak form efficiency is a subset of semistrong
7. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all
8. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
9. The EMH only says, within the bounds of increasingly strong assumptions about the information
processing of investors, that assets are fairly priced. An implication of this is that, on average, the
typical market participant cannot earn excessive profits from a particular trading strategy. However,
10. a. If the market is not weak form efficient, then this information could be acted on and a profit
b. Under (2), if the market is not semistrong form efficient, then this information could be used to
buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.
c. Under (3), if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock
is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three
11. A technical analyst would argue that the market is not efficient. Since a technical analyst examines
past prices, the market cannot be weak form efficient for technical analysis to work. If the market is
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CHAPTER 14 B-
12. Investor sentiment captures the mood of the investing public. If investors are bearish in general, it
may be that the market is headed down in the future since investors are less likely to invest. If the
sentiment is bullish, it would be taken as a positive signal to the market. To use investor sentiment in
13. Taken at face value, this fact suggests that markets have become more efficient. The increasing ease
with which information is available over the Internet lends strength to this conclusion. On the other
hand, during this particular period, large-capitalization growth stocks were the top performers.
14. It is likely the market has a better estimate of the stock price, assuming it is semistrong form
efficient. However, semistrong form efficiency only states that you cannot easily profit from publicly
b. Only scenario (ii) indicates market efficiency. In that case, the price of the stock rises
16. False. The stock price would have adjusted before the founder’s death only if investors had perfect
forecasting ability. The 12.5 percent increase in the stock price after the founder’s death indicates
that either the market did not anticipate the death or that the market had anticipated it imperfectly.
17. The announcement should not deter investors from buying UPC’s stock. If the market is semistrong
form efficient, the stock price will have already reflected the present value of the payments that UPC
18. The market is often considered to be relatively efficient up to the semistrong form. If so, no
systematic profit can be made by trading on publicly-available information. Although illegal, the
lead engineer of the device can profit from purchasing the firm’s stock before the news release on the
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CHAPTER 14 B-
19. Under the semistrong form of market efficiency, the stock price should stay the same. The
accounting system changes are publicly available information. Investors would identify no changes
20. Because the number of subscribers has increased dramatically, the time it takes for information in the
newsletter to be reflected in prices has shortened. With shorter adjustment periods, it becomes
impossible to earn abnormal returns with the information provided by Durkin. If Durkin is using
21. You should not agree with your broker. The performance ratings of the small manufacturing firms
22. Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect
b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for
c. No. The information is already public, and thus, already reflected in the stock price.
24. Serial correlation occurs when the current value of a variable is related to the future value of the
variable. If the market is efficient, the information about the serial correlation in the macroeconomic
variable and its relationship to net earnings should already be reflected in the stock price. In other
25. The statement is false because every investor has a different risk preference. Although the expected
26. The share price will decrease immediately to reflect the new information. At the time of the
27. In an efficient market, the cumulative abnormal return (CAR) for Prospectors would rise
substantially at the announcement of a new discovery. The CAR falls slightly on any day when no
discovery is announced. There is a small positive probability that there will be a discovery on any
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CHAPTER 14 B-
28. Behavioral finance attempts to explain both the 1987 stock market crash and the Internet bubble by
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. To find the cumulative abnormal returns, we chart the abnormal returns for each of the three airlines
for the days preceding and following the announcement. The abnormal return is calculated by
Abnormal returns ( Ri – R M)
Days from
announcement Delta United American Sum
Average
abnormal return
Cumulative
average residual
–4 –.2 –.2 –.2 –.6 –.2 –.2
–3 .2 –.1 .2 .3 .1 –.1
–2 .2 –.2 0 0 0 –.1
Cumulative Abnormal Returns
-0.2
-0.1
-0.1
-0.1
1.7
1.8
1.8
1.7
1.6
-0.5
0
0.5
1
1.5
2
-4 -3 -2 -1 0 1 2 3 4
Days from announcement
CAR
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CHAPTER 14 B-
The market reacts favorably to the announcements. Moreover, the market reacts only on the day of
2. The diagram does not support the efficient markets hypothesis. The CAR should remain relatively
flat following the announcements. The diagram reveals that the CAR rose in the first month, only to
3. a. Supports. The CAR remained constant after the event at Time 0. This result is consistent with
market efficiency, because prices adjust immediately to reflect the new information. Drops in
CAR prior to an event can easily occur in an efficient capital market. For example, consider a
b. Rejects. Because the CAR increases after the event date, one can profit by buying after the
c. Supports. The CAR does not fluctuate after the announcement at Time 0. While the CAR was
d. Supports. The diagram indicates that the information announced at Time 0 was of no value.
4. Once the verdict is reached, the diagram shows that the CAR continues to decline after the court
decision, allowing investors to earn abnormal returns. The CAR should remain constant on average,
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