Chapter 5
2. The fact that government bonds earned a higher rate of return than common stocks in one year
is not evidence that investors are suddenly willing to settle for lower returns on stocks than
bonds. It means that investors’ expectations were not met, or said differently, that investors
4. The yield on the bond with the call provision will be higher. The call option gives the issuer a
valuable option and investors will demand compensation for this option in the form of a higher
yield. For example, suppose the interest rate declines in year six. The price of the non-callable
6. a. The annual returns are as follows:
Annual Return
Stock 1
($1.50 + $46.75 – $42.50)/$42.50 = 13.5%
Stock 2
($0.00 + $1.36 – $1.25)/$1.25 = 8.8%
Bond 1
($41.00 + $1,048 – $1,020)/$1,020 = 6.8%
b. Share repurchases do not affect these calculations. Share repurchase will increase the
8. The price will be set at 5% below the current price, or at 0.95 × 10 = $9.50. The underwriters
will take $0.50 per share, leaving $9.00/share for Magenta. Magenta needs to receive $51
10. a. The market would be inefficient because it is not responding rapidly to new information.
b. Buy the target’s stock immediately on the announcement. Sell in four days after it has
risen and pocket a nice profit.
e. This is not necessarily evidence of market inefficiency. If investors expect the bid to be
followed by higher bids from other potential buyers, the market will rationally and
efficiently drive the price above the initial bid.
12. Earning high returns in an efficient market is like winning at roulette. In any random process,
there will be winners and losers, and some winners might win big. Earning consistently high
The continued investment success of Warren Buffett and his associated value investors does
pose a challenge to market efficiency. The argument that this success is just luck stretches
credulity. A more likely explanation is that high intelligence, extreme emotional discipline,
14. a. This is a call option. You have the option to buy.
c. $2.09 × 1,000 options = $2,090. There is a much better chance CSCO stock will rise to
high levels in three years than in five months.