978-1259285295 Chapter 8 Solution Manual

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Chapter 8

Stocks, Stock Markets, and Market Efficiency

Conceptual and Analytical Problems

1. Explain why being a residual claimant makes stock ownership risky. (LO1)

Answer: Stockholders do not receive dividends unless all of the firm’s creditors

2. Do individual shareholders have an effective say in corporate governance matters? (LO1)

Answer: In principle, shareholders have a say on corporate affairs. They elect

members of the company’s board of directors and can vote on important issues

raised at the company’s annual meeting. Furthermore, they can offer resolutions

3. Consider the following information on the stock market in a small economy. (LO2)

Company Shares

Outstanding

Price,

beginning

of year

Price, end

of year

1 100 $100 $94

2 1000 $20 $25

3 10,000 $3 $6

a. Compute a price-weighted stock price index for the beginning of the year and

the end of the year. What is the percentage change?

b. Compute a value-weighted stock price index for the beginning of the year and

the end of the year. What is the percentage change?

Answer:

a. For a price-weighted index, we find the cost of buying one share of each

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

b. The percentage change in a value-weighted index is given by percentage

change in the sum of the values of the companies. At the beginning of the

year, the value of the companies is given by

At the end of the year, the value is

4. To raise wealth and stimulate private spending, suppose the central bank lowers interest

rates, making stock market investment relatively attractive. Which stock market index

would you monitor to judge the effectiveness of the policy: the Dow Jones Industrial

Average or the S&P 500? Why? (LO2)

Answer: Since the S&P 500 is a value-weighted index, it tracks the value of

5. Suppose you see evidence that the stock market is efficient. Would that make you more or

less likely to invest in stocks for your 401(k) retirement plan when you get your first job?

(LO4)

Answer: Efficient markets suggest that all relevant information is incorporated

into stock prices, and that changes in prices on a particular day reflect that day’s

6. Professor Siegel argues that investing in stocks for retirement may be less risky than

investing in bonds. Would you recommend this approach to an individual in his or her

early 60s? (LO4)

Answer: The closer an individual is to retirement, the less time for a portfolio to

overcome downward shocks to its value. Consequently. allocating retirement

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

7. How do venture capital firms, which specialize in identifying and financing promising

but high-risk businesses, help the economy grow? (LO5)

Answer: New companies often have difficulty finding financing to put their plans

into action. Venture capital firms specialize (say, in one particular industry) in

8. *What are the advantages of holding stock in a company versus holding bonds issued by

the same company? (LO1)

Answer: Stocks represent a share of ownership in the company and give the

holder a share in the future profits of the company. If the company, for example,

makes a great discovery, invents the next great product etc., stock holders get to

9. If Professor Siegel is correct that stocks are less risky than bonds, then the risk premium

on stock may be zero. Assuming that the risk-free interest rate is 2½ percent, the growth

rate of dividends is 1 percent and the current level of dividends is $70, use the

dividend-discount model to compute the level of the S&P 500 that is warranted by the

fundamentals. Compare the result to the current S&P 500 level, and comment on it.

(LO4)

Answer:

10. *Why is a booming stock market not always a good thing for the economy? (LO5)

Answer: If stock prices are rising for reasons that are not related to economic

fundamentals, there may be a misallocation of resources in the economy.

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

11. The financial press tends to become excited when the Dow Jones Industrial Average rises

or falls sharply. After a particularly steep rise or fall, newspapers may publish tables

ranking the day’s results with other large advances or declines. What do you think of

such reporting? If you were asked to construct a table of the best and worst days in stock

market history, how would you do it, and why? (LO2)

Answer: This type of reporting can be misleading because it ignores the level of

12. You are thinking about investing in stock in a company which paid a dividend of $10 this

year and whose dividends you expect to grow at 4 percent a year. The risk free rate is 3

percent and you require a risk premium of 5 percent. If the price of the stock in the

market is $200 a share, should you buy it? (LO3)

13. *Consider again the stock described in Problem 12. What might account for the

difference in the market price of the stock and the price you are willing to pay for the

stock? (LO3)

Answer: The difference could reflect the fact that you require a lower risk

14. You are trying to decide whether to buy stock in Company X or Company Y. Both

companies need $1000 capital investment and will earn $200 in good years (with

probability 0.5) and $60 in bad years. The only difference between the companies is that

Company X is planning to raise all of the $1000 needed by issuing equity while

Company Y plans to finance $500 through equity and $500 through bonds on which 10%

interest must be paid.

Construct a table showing the expected value and standard deviation of the equity

return for each of the companies. (You could use Table 8.3 as a guide.) Based on

this table, in which company would you buy stock? Explain your choice. (LO3)

Answer:

% equity % bonds Pay on Pay to Equity Expected Standard

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

bonds equity

holders

return Value Deviatio

(Remember, the expected value of the equity return is calculated as a % of 500 –

the amount put into equity.)

Which company you choose depends on your attitude toward risk. If you are

15. Your brother has a $1000 and a one-year investment horizon and asks your advice about

whether he should invest in a particular company’s stock. What information would you

suggest he analyze when making his decision? Is there an alternative investment strategy

to gain exposure to the stock market you might suggest he consider? (LO4)

Answer: You should explain that the return on his investment will depend on the

dividend he may be paid and the movement in the stock price over the year. You

16. Given that many stock market indices across the world fell and rose together during the

financial crisis of 2007-2009, do you think investing in global stock markets is an

effective way to reduce risk? Why or why not? (LO2)

Answer: While it is true that movements in stock market indices across the world

have become more highly correlated over time, as long as they are not perfectly

correlated, there are benefits from spreading your investments. (Recall how

spreading reduces risk from chapter 5.)

17. Do you think a proposal to abolish limited liability for stockholders would be supported

by companies issuing stock? (LO1)

Answer: No. The obvious downside would be that stocks would become much

less attractive as an investment, making it much costlier for firms to raise funds

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

18. You peruse the available records of some public figures in your area and notice that they

persistently gain higher returns on their stock portfolios than the market average. As a

believer in efficient markets, what explanation for these rates of returns seems most likely

to you? (LO5)

Answer: Your first instinct is that the public officials have access to inside

19. Do you think that widespread belief in the efficient markets theory was a significant

contributor to the 2007-2009 financial crisis? Why or why not? (LO5)

Answer: The efficient market hypothesis does not postulate that market prices of

securities are always correct, but that they reflect all known information that

20. Based on the dividend-discount model, what do you think would happen to stock prices if

there were an increase in the perceived riskiness of bonds? (LO3)

Answer: If investors perceive bonds are more risky, then the relative riskiness of

stocks will fall. Stocks would become relatively more attractive, requiring a

21. *Use the dividend-discount model to explain why an increase in stock prices is often a

good indication that the economy is expected to do well. (LO3)

Answer: How well investors expect the economy to do is reflected in the expected

growth rate of dividends, g. When investors are optimistic about the future, they

Data Exploration:

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

1. How well does the stock market anticipate the behavior of the economy? Plot since 1950

the percentage change from a year ago of the Dow Jones Industrial Average. Is the index

a reliable predictor of business cycle downward turns (depicted by the graph by vertical,

shaded bars)? (LO5) (Hints: At the FRED Web site, click on “Data Tools” and then

“Create Your Own Graphs.” In the “Add Data Series” box, input the code for Dow

Jones Industrial Average (DJIA). Change the “Frequency” to monthly, set the start date

in the “Observation Date Range” to January 1950, and change the “Units” to “Percent

Change from Year Ago.”)

Answer: The data plot is:

Among various measures of financial conditions, a broad index of the stock market is one

of the best predictors of economic downturns and upturns because investors are

forward-looking and know that future profits and dividends depend on prospective

2. Why might the stocks of small firms outperform large firms over long periods of time?

Will this hold over short periods of time, too? Plot since 1979 the stock indexes for small

firms (FRED code: WILLSMLCAP) and large firms (FRED code: WILLLRGCAP) using

annual data scaled to a common base year of 1979=100. (LO3) (Hints: At the FRED Web

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

site, click on “Data Tools” and then “Create Your Own Graphs.” In the “Add Data

Series” box, input the code for the Wilshire U.S. Small Cap Total Market Index (FRED

code: WILLSMLCAP) and select “Annual” from the Frequency dropdown box. At the

Units box, select “Index (Scale value to 100 for chosen period).” At “Enter an

Observation Date” type “1979-01-01” to start the scale at 100 in 1979. Next, at “Add

Data Series,” add the Wilshire U.S. Large Cap Total Market Index (FRED code:

WILLLRGCAP), specify the frequency as annual, and then “Redraw Graph.” Note that

both indexes start at the same value of 100 in 1979.)

Answer: The data plot is:

Because risk requires compensation, we expect the stocks of small firms (that

have a higher probability of failure) to offer higher returns than the stocks of large

3. Compare and contrast the evolution of two leading stock indexes. Plot since 1960 on a

quarterly basis the Dow Jones Industrial Average (FRED code: DJIA) and the S&P 500

(FRED code: SP500) scaled to a common base quarter of 1960 Q1=100 (LO2)

Answer: The data plot is:

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Scaling each index to begin at 100 in 1960 shows the rise in the S&P 500 has

greater than on the Dow Jones average. Over time, the S&P index includes newer

4. The Dow Jones Industrial Average (FRED code: DJIA) is a price-weighted index of 30

stocks and the S&P 500 index (FRED code: SP500) is a value-weighted average of 500

stocks. Find out which is more volatile. Plot on a quarterly basis since 1970 the percent

change from a year ago of each index. Download the data and compute the standard

deviation for each series over the period. (LO3) (Hints: At the FRED Web site, click on

“Data Tools” and then “Create Your Own Graphs.” In the “Add Data Series” box, input

the code for the Dow (FRED code: DJIA). Next, set the start date to January 1970 in the

“Observation Date Range” box, select “Quarterly” in the Frequency box, choose

“Percent Change from Year Ago” in the Units box, and click “Redraw Graph.” Next, at

“Add Data Series,” repeat these procedures for the S&P500 (FRED code: SP500). Then,

download the data to a spreadsheet.)

Answer: The plot is:

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

The principle of diversification (“spreading of risks”) might encourage you to

expect the variability of the S&P 500 to be lower than that of the Dow Jones.

However, a portfolio of 20 to 30 stocks spread across industries probably captures

5. Have stock dividends become a more important source of income to U.S. households?

Plot since 1959 the share of dividend income (FRED code: B703RC1Q027SBEA) in

personal disposable income (FRED code: DSPI). Can you explain the 50-year trend?

(LO5) (Hints: At the FRED Web site, click on “Data Tools” and then “Create Your Own

Graphs.” In the “Add Data Series” box, input the code for personal dividend income

(FRED code: B703RC1Q027SBEA). Change the start observation to January 1959 at the

“Observation Date Range” box. Go to the “Add Data Series” box again, click on the

“Line 1” button, and then input the code for disposable personal income (FRED code:

DSPI). At the Formula box, input “(a / b)*100” (without the quotes) and then select

“Redraw Graph.”)

Answer: The data plot is:

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Chapter 08 – Stocks, Stock Markets, and Market Efficiency

Several factors may explain the rise in dividend income as a proportion of

disposable income. Ownership of equity has become much more widespread over

this period. Part of that shift may reflect demographics, as a larger share of the

* indicates more difficult problems

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