Finance Chapter 14 Homework This Price Behavior Indicates That The Market

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

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

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 are fairly

uncertain. Efficiency of markets does not eliminate that uncertainty and therefore does not imply

perfect forecasting ability.

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

form efficiency.

8. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators

provide liquidity to markets and thus help to promote efficiency.

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

10. a. If the market is not weak form efficient, then this information could be acted on and a profit

earned from following the price trend. Under (2), (3), and (4), this information is fully impounded

in the current price and no abnormal profit opportunity exists.

b. Under (2), if the market is not semistrong form efficient, then this information could be used to

11. A technical analyst would argue that the market is not efficient. Since a technical analyst examines

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

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

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 available

15. a. Aerotech’s stock price should rise immediately after the announcement of the positive news.

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

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

19. Under the semistrong form of market efficiency, the stock price should stay the same. The accounting

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

21. You should not agree with your broker. The performance ratings of the small manufacturing firms

23. a. No. Earnings information is in the public domain and reflected in the current stock price.

b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for

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

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

announcement, the price of the stock should immediately decrease to reflect the negative information.

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

28. Behavioral finance attempts to explain both the 1987 stock market crash and the internet bubble by

changes in investor sentiment and psychology. These changes can lead to non-random price behavior.

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

subtracting the market return from a stock’s return on a particular day, Ri – RM. Group the returns by

the number of days before or after the announcement for each respective airline. Calculate the

cumulative average abnormal return by adding each abnormal return to the previous day’s abnormal

return.

Abnormal returns (Ri – RM)

Days from

announcement

Delta

United

American

Sum

Average

abnormal return

Cumulative

average residual

–4

–.2

–3

.2

–.1

.2

.3

.1

–.1

–1

.2

–.4

0

–.1

0

3.3

.2

1.9

5.4

1.8

1.7

1

.2

.1

0

.3

.1

1.8

2

.1

0

1.8

4

–.1

1.6

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 drift

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

sample of forced removals of the CEO. Since any CEO is more likely to be fired following bad

Cumulative Abnormal Returns

1.6

1.8

-0.5

1

1.5

2

-4 -3 -2 -1 0 1 2 3 4

Days from announcement

4. Once the verdict is reached, the diagram shows that the CAR continues to decline after the court