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Chapter 7
ANSWERS TO QUESTIONS
1. What basic principle of finance can be applied to the valuation of any investment asset?
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
estimating bond cash flows. Which security would you predict to be more volatile?
There are two cash flows from stock: periodic dividends and a future sales price. Dividends
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
policy be used to prick a market bubble? Explain using the Gordon growth model.
A stock market bubble can occur if market participants either believe that dividends will have
4. If monetary policy becomes more transparent about the future course of interest rates, how
will stock prices be affected, if at all?
With more certainty over the course future interest rates will follow, uncertainty and risk
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14. Suppose that in every last week of November stock prices go up by an average of 3%. Would
this constitute evidence in favor of or against the efficient market hypothesis?
If there is a phenomenon that takes place regularly and it is not incorporated into people’s
15. “An efficient market is one in which no one ever profits from having better information than
the rest of the market participants.” Is this statement true, false, or uncertain? Explain your
answer.
16. If higher money growth is associated with higher future inflation, and if announced money
growth turns out to be extremely high but is still less than the market expected, what do you
think will happen to long-term bond prices?
17. “Foreign exchange rates, like stock prices, should follow a random walk.” Is this statement
true, false, or uncertain? Explain your answer.
18. Assume that the efficient market hypothesis holds. Marcos has been recently hired by a
brokerage firm and claims that he now has access to the best market information. However,
he is the “new guy,” and no one at the firm tells him much about the business. Would you
expect Marcos’s clients to be better or worse off than the rest of the firm’s clients?
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19. Suppose that you work as a forecaster of future monthly inflation rates and that your last six
forecasts have been off by minus 1%. Is it likely that your expectations are optimal?
For your expectations to be optimal, they have to include all available information up to date,
20. In the late 1990s, as information technology advanced rapidly and the Internet was widely
developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets
began to unwind and then crashed, with many commentators identifying the previous few
years as a “stock market bubble.” How might it be possible for this episode to be a bubble
but still adhere to the efficient market hypothesis?
It may be considered a bubble in that stock market prices rose well above true fundamental
21. Why might the efficient market hypothesis be less likely to hold when fundamentals suggest
stocks should be at a lower level?
Behavioral finance suggests that when stock prices rise, market participants are less likely to
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
be able to sell in one year for $20, assuming you require a 15% return.
$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
average, in the foreseeable future. The firm’s last dividend was $3. Compute the current
price of this stock, assuming the required return is 18%.
= − − =
0$3 (1.07)/( 0.18 0.07) $29.18P
