Chapter 7
ANSWERS TO QUESTIONS
1. What basic principle of finance can be applied to the valuation of any investment asset?
investment will generate over its life.
2. What are the two main sources of cash flows for a stockholder? How reliably can these cash
flows be estimated? Compare the problem of estimating stock cash flows to the problem of
the dividends that will be paid at some date even further in the future. Bond cash flows also
consist of two parts, periodic interest payments and a final maturity payment. These
3. Some economists think that central banks should try to prick bubbles in the stock market
before they get out of hand and cause later damage when they burst. How can monetary
climb. By raising interest rates the central bank can cause the required rate of return on
equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates
keeping stock prices from climbing.
4. If monetary policy becomes more transparent about the future course of interest rates, how
higher stock price. In addition, with a reduction in the uncertainty of future short-term
pushing stock prices higher.
5. “Forecasters’ predictions of inflation are notoriously inaccurate, so their expectations of
answer.
False. Expectations can be highly inaccurate and still be rational, because optimal forecasts
errors are large.
6. “Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it
why not?
7. If a forecaster spends hours every day studying data to forecast interest rates, but his
interest rates will be identical to today’s. His forecasts are therefore not optimal, and he does
not have rational expectations.
8. “If stock prices did not follow a random walk, there would be unexploited profit
this case, there would be unexploited profit opportunities in the market and expectations
profit opportunity would not exist.
9. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that
when you see that the money supply has sharply increased in the past week, you should go
out and buy stocks? Why or why not?
No, you shouldn’t buy stocks, because the rise in the money supply is publicly available
information that will be already incorporated into stock prices. Hence you cannot expect to
earn more than the equilibrium return on stocks by acting on the money supply information.
10. If the public expects a corporation to lose $5 per share this quarter and it actually loses $4,
which is still the largest loss in the history of the company, what does the efficient market
hypothesis predict will happen to the price of the stock when the $4 loss is announced?
The stock price will rise. Even though the company is suffering a loss, the price of the stock
reflects an even larger expected loss. When the loss is less than expected, efficient markets
theory then indicates that the stock price will rise.
11. If you read in the Wall Street Journal that the “smart money” on Wall Street expects stock
selling your stocks.
12. If your broker has been right in her five previous buy and sell recommendations, should you
continue listening to her advice?
expect the broker to beat the market in the future.
13. Can a person with rational expectations expect the price of a share of Google to rise by 10%
in the next month?
opportunity in the market, which would have been eliminated in an efficient market. The only
14. “If most participants in the stock market do not follow what is happening to the monetary
the monetary aggregates is that some market participants eliminate unexploited profit
efficient.
15. “An efficient market is one in which no one ever profits from having better information than
answer.
False. The people with better information are exactly those who make the market more
better information.
16. If higher money growth is associated with higher future inflation, and if announced money
be lowered, and as we learned in Chapter 7, long-term interest rates would fall. The decline
17. “Foreign exchange rates, like stock prices, should follow a random walk.” Is this statement
true, false, or uncertain? Explain your answer.
foreign exchange market is efficient, these unexploited profit opportunities cannot exist and
18. Can we expect the value of the dollar to rise by 2% next week if our expectations are rational?
exchange rate could not exist.
19. “Human fear is the source of stock market crashes, so these crashes indicate that
expectations in the stock market cannot be rational.” Is this statement true, false, or
uncertain? Explain your answer.
public.
20. In the late 1990s, as information technology advanced rapidly and the Internet was widely
It may be considered a bubble in that stock market prices rose well above true fundamental
values. However, given the relatively new and rapid technology advances during the time,
considering much of the technology was new and had seemingly unlimited growth potential.
21. Why might the efficient market hypothesis be less likely to hold when fundamentals suggest
stocks should be at a lower level?
nearly unlimited losses, very little short selling occurs in practice. In addition, short selling is
sometimes seen as taboo, since it is viewed as profiting off the losses of others.
ANSWERS TO APPLIED PROBLEMS
22. Compute the price of a share of stock that pays a $1 per year dividend and that you expect to
$1/(1.15)+$20/(1.15)=$18.26
23. After careful analysis, you have determined that a firm’s dividends should grow at 7%, on
P
0=$3´(1.07)/(–0.18–0.07)=$29.18
24. The current price of a stock is $65.88. If dividends are expected to be $1 per share for the
next five years, and the required return is 10%, then what should the price of the stock be in
2 3 4 5
P55. No, the current stock price will not increase by the full dollar. Since the future
5, or $0.62.
25. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split,
the company had a market value of $5 billion with 100 million shares outstanding. Assuming
efficiency?
Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split conveys
no new information, the market value of the company does not change, remaining at $5
market will correct itself. Another possibility is that the stock split actually conveyed
information about the company. Investors may believe (possibly incorrectly) that the
stock split.
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database, and find data on the Dow Jones
Industrial Average (DJIA). Assume the DJIA is a stock that pays no dividends. Apply the one-
instead. How does this change the required rate of return?
The DJIA on June 5, 2014 was 16,836.11, and one year prior on June 5, 2013 was 14,960.60.
12.5% required rate of return on equity investment. If a $100 dividend were paid out, then
14,960.60 = 100/(1 + ke) + 16,836.11/(1 + ke) gives ke = 13.2% required rate of return on
equity investment.
of data available.
From 1960 to 2013, the average growth rate of dividend payments was 8.6%.
share of DJIA.
The required rate of return under the Gordon growth model can be found by solving for
ke: 16,836.11 = 100/(ke – 0.086), or ke = 0.092, or 9.2%.