Analysis for Financial Management, 10e

SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS

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 were surprised. To take on additional risk, risk-averse investors require additional
expected return. But expected returns are not the same as realized returns. Because stocks
and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher
returns than stocks in some years. But the expected returns on common stocks will always
be higher than the expected returns on government bonds.
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 bond will rise as the holder earns an above market current yield, while the price
of the callable bond will remain at $1,000 in anticipation that the issuer will call the bond
and refinance at the new lower rate. Holders of the callable bonds will demand a higher
yield to compensate for such eventualities.
6. a. The annual returns are as follows:
Stock 1
Stock 2
Bond 1

Annual Return
($1.50 + $46.75 - $42.50)/$42.50 = 13.5%
($0.00 +$1.36-$1.25)/$1.25 = 8.8%
($41.00 +$1,048-$1,020)/$1,020 = 6.8%

b. Share repurchases do not affect these calculations. Share repurchase will increase the
percentage ownership of each remaining share, and will likely increase the end of year share
price. However, this increase is already reflected in the observed end of year price and thus
in the annual return.
8. The observed financing pattern can be attributed to several causes. First, there are significant
fixed costs in selling bonds that make it uneconomical to raise the modest sums usually
sought by small firms. Second, small firms, especially privately-held small firms, face
information asymmetry problems. Most investors know comparatively little about small
firms and have little incentive to spend the resources necessary to learn more. This creates a
market niche for local banks that are often familiar with local borrowers via other business
relations and community activities. The banks are able to capitalize on this information
advantage by charging a premium over public market interest rates. A danger to banks is

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

that this information advantage appears to be dwindling over time as information technology
improves.
10. a. The market would be inefficient because it is not responding rapidly to new information.
b. Buy the targets stock immediately on the announcement. Sell in four days after it has
risen and pocket a nice profit.
c. If many investors pursued this strategy, the increased demand on announcement would
cause the price to jump sharply immediately after the announcement. The price response
would become efficient.
d. This problem illustrates the statement quite clearly. People discover an inefficiency, and
in the process of capitalizing on the inefficiency, they drive it away.
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 returns over time is also possible in an efficient market, just like a gambler
on a lucky streak might win repeatedly at roulette. The relevant questions are whether the
very high returns or the length of the winning streak is inconsistent with blind luck or not.
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,
and driven dedication do enable some people to earn superior market returns. At the same
time, evidence tells us that these individuals are extremely few and far between, and that it is
virtually impossible to identify these individuals with any reliability. It should also be noted
that Warren Buffett is not a passive stock picker, that much like a private equity firm has
company, Berkshire Hathaway, adds considerable value to acquired companies via changes
in operational, management, incentive, and governance practices.
14. a. This is a call option. You have the option to buy.
b. According to Roberts Option Pricer the value of the option per share is $7.84. You own
1,000 options, so in total they are worth $7,840.
c. $2.88 x 1,000 options = $2,880. There is a much better chance FO stock will rise to high
levels in three years than in five months.
d. $16.32 x 1,000 options = $16,320. The more volatile FO stock, the more likely it will rise
to high levels during the life of the option.

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.