# Investors in the Stock Markets

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```					                                                                                   Corporate Finance

Quiz 1 - Spring 1998                                                           Important note: On the earlier quizzes, the risk premium used is 5.5% and it is not
Problem 1                                                                      given in the problem. It would have been looked up in the lecture notes - long term geometric averate premium over T.Bonds
Jensen's Alpha = Intercept - Riskfree Rate (1- Beta)                           and arithmetic average over T.Bills for short term expected returns.
+ 0.1% = - 0.2% - Riskfree Rate (1 - 1.50)
Solving for Riskfree Rate, we get
Riskfree Rate = 0.6% a month

Problem 2
Unlevered Beta for Food Business = 0.92/(1+(1-.4)(.25)) =                                             0.8
Unlevered Beta for Tobacco Business = 1.17/(1+(1 - .4)(.5)) =                                         0.9
Unlevered Beta for the Company = 0.8 (10/25) + 0.9 (15/25) =                                         0.86 ! Weighted by values of each division
Levered Beta for the Company = 0.86 (1 + (1-.4)(1.00)) =                                            1.376
Cost of Equity for the Company = 6% + 1.376 (5.5%) =                                              13.57%

Problem 3a.
Unlevered Beta after sale = 0.90 (Food business is sold off)
Debt after divestiture = (12.5 billion - 10 billion) = 2.5 billion
Equity after divestiture = 12.5 billion
Debt/Equity Ratio after the action = 2.5/12.5 = 0.2
New Levered Beta = 0.90 (1 + (1-.4) (.2)) =                                             1.008

Problem 3b.
Unlevered Beta after sale = 0.90 (15/25) + 0.00 (10/25) =                                            0.54 ! Beta of cash is zero
Levered Beta after sale = 0.54 (1 + (1-.4) (1.00)) =                                                0.864

Quiz 1 - Spring 1999
Problem 1
a. Management power increases. Board will become more CEO compliant.
b. Stockholder power increases. New directors are likely to be stockholder focused.
c. No effect. The additional shares are non-voting.
d. Management power increases. Hostile takeovers operate as a disciplinary mechanism.

Problem 2
Quarterly Excess Return = (1.32)^1/4-1 =                               7.19% ! Okay if you use 8% as quarterly excess return
Intercept - Riskfree Rate (1-Beta) = Excess Return
Quarterly Riskfree Rate=(1.048)^1/4-1 =                                1.18% !Again, okay if you use 1.2% as you quarterly riskfree rate
Intercept - 1.18% (1-1.50) = 7.19%
Solving for the intercept,
Intercept = 7.19% + 1.18% (1-1.5) =                                    6.60%

Problem 3
0.70 (Raw Beta) + 0.30 (1.00) = 1.70
Raw Beta =                                               2
Range on Beta = 1.65-2.35

Problem 4

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Current Beta = 1.20
Assets                                                      Liabilities
Cash                                             25         Equity                    100
New Age                                          75
0.75 (Beta of New Age Business) + 0.25 (0) = 1.20
Beta of New Age Business =                                                1.6
After the transaction,
Assets                                                      Liabilities
New Age                                          75         Debt                        15
Equity                      60
Debt/Equity Ratio = 15/60 = 0.25
New Beta = 1.60 (1 + (1-0.4)(0.25)) =                                                 1.84

Quiz 1a: Spring 1999
Problem 1
a. Net effect will be small since the CEO picks the directors.
b. Depends on the institutions. While institutions investors have more clout, they are often passive.
c. Stockholder power increases. Lender will want a role in management.
d. Stockholder power increases. Increases the perceived likelihood of a hostile acquisition.

Problem 2
Jensen's alpha = -1.31% - .45% (1-0.85) =                                                         -1.38% ! Made 5.4% into a monthly riskfree rate = 5.4%/12 = .45%
Annualized Jensen's Alpha= ( 1- .0138)^(12)-1 =                                                  -15.36%

Problem 3
Unlevered Beta of Golden Books existing business = 0.85/(1+(1-.40)(.5)) =                                                      0.65
Unlevered Beta of video business = 1.10/(1+(1-.4)(.25)) =                                                                      0.96
Unlevered beta of Golden Books (new business mix) = 0.65 (.5) + 0.96(.5) =                                                     0.81
Levered Beta for Golden Books = 0.81 (1+(1-.4)(1.50)) =                                                                        1.53

Quiz 1: Spring 2000
Problem 1
On this question, if you did lose points, odds are that you do not agree with my grading. I have tried
give you my rationale below. If you do not agree with it, or you can make a good case for your answer,
come by and make your argument. I am not unreasonable and will give you full credit
a. Stockholder power increases: Calpers will push for changes in management
b. Management power increases: More difficult to change the board when only one-third
of the board gets elected each year.
(I understand your argument that it depends upon who picks the directors. If the CEO does, many of you
argued, it makes no difference. However, remember that even if the CEO picks the directors, the stockholders
have to approve those choices. I know that stockholders do not always exercise this power, but at least they
have one chance each year to change their ways. This is reduced when only one third gets elected each year)
(Some of you argued that this makes no difference, but I think it does. If you are a stockholder in a firm where
the managers control the flow of information and you have no other sources of analysis of information, it seems

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to me that you are at a disadvantage. Increasing information increases your power)
d. Management power increases
(On this one, I was torn. The CEO, who is part of incumbent management now gets more voting power to back her
up. At the same time, this reduces the conflict between stockholders and managers. If you did state that as a
reason for stockholder power increasing, I gave you full credit. If you did not, and that was why you chose this option
I will give you full credit)

Problem 2
Since the marginal investor is globally diversified, I would use the MSCI regression. To get
a DM cost of equity, I would use the DM riskfree rate.
Expected return = 4.5% + 0.8 (6%) =                                          9.30%

Problem 3
a.
Unlevered Beta for General Systems = 1.20/(1+(1-.4)(4/10)) =                                                0.9677
Unlevered Beta for FastWorks = 1.40/(1+(1-.4)(1/8)) =                                                       1.3023
Unlevered Beta of combined firm = 0.9677 (14/23) + 1.3023 (9/23) =                                          1.0987 ! Use firm value weights, not equity weights

b.
Beta after the transaction =                                              1.52
Solving for the Debt to equity ratio =
1.52 = 1.0987 (1 + (1-.4)(D/E))
D/E =                                        63.91%                                                 ! You cannot keep equity fixed and try to solve for the debt
Debt to capital ratio=                       38.99% ! Convert D/E to D/Capital                      If you do, you will have a problem getting the balance sheet
Debt after transaction = (D/ (D+E)) (Firm value) = .3899 (23) =                                8.97 to balance and the right debt to equity ratio.
Debt from two firms = 4 + 1 =                                                                     5
Debt issued on transaction =                                                                   3.97

A Quick Check
Assets                                                      Liabilities
Gen Systems                                             14 Debt                       9
Fastworks                                                9 Equity                    14

(Put your answer in this balance sheet and see if it balances, and yields a debt to equity ratio of 0.64)

Quiz 1: Spring 2001
Problem 1
a. Weekly riskfree rate =                            0.10%
Jensen's alpha (weekly) =                            0.14% ! 0.06% - 0.10% (1-1.8)
Jensen's alpha (annual) =                            7.28%

b. Range on beta =                          1.46 - 2.14
Since this is approximately one standard error from the estimate,
Standard Error =                                       0.34

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c. I would use the geometric premium over the long term bond:
Geometric premium =                                 4.70% ! 10.9% - 6.2%                ! You have to use the current T.Bond rate
Cost of equity = 5.4% + 1.80 (4.7%) =             13.86%                 ! The best premium to use is a geometric premium for stocks over T.Bonds - Here you
have to stay with the historical data.

d. No. (Or at least, not necessarily). You would need to trade to be the marginal
investor and founder/owners generally do not do a lot of trading.
In a sense, it does not really matter whether the remaining 80% is owned by individuals or institutions. What matters is whether

Problem 2
Unlevered beta for Vivant =                           0.90
Current market value of equity =                       300
After transaction:
Unlevered beta for software firms =                   1.25 ! 1.40/(1+(1-.4)(.20))
Unlevered beta for Vivant after merger = 0.90 (300/500) + 1..25 (200/500) =                            1.04
Debt to Equity ratio after the transaction =   0.33333333 ! 125/375
New levered beta = 1.04 (1 + (1-.4) (.3333)) =       1.248

Quiz 1: Spring 2002
Problem 1
a. True. (I must admit that this was a tough one to reason through. The empirical evidence indicates that smaller boards are more effective. As some of you point out, though, you can make a good case for lar
b. False. Insider dominated boards make it very unlikely that you will challenge incumbent management.
c. False. See lecture notes. On average, stock prices go up on investment announcements.
d. False. The marginal investor needs to trade, not just hold stock.

Problem 2
a, You cannot draw a conclusion without knowing the riskfree rate. (If the monthly riskfree rate >0.5%, the stock did better than expected
If riskfree rate < 0.5%, the stock did worse than expected)
b. You should use the treasury bond rate and the implied equity risk premium
Cost of equity = 4.9% + 1.2 (3.62%) =                                                      9.24% ! -1 point for wrong riskfree rate; -1 point for wrong risk premium

Problem 3
a. Unlevered beta based upon regression = 0.848/(1+ (1-.4) (.10)) =                                                    0.80 ! Use the historical D/E ratio to unlever
b. New unlevered beta                                                                                                       If you used the current D/E: -.5 point
Unlevered beta alue
Trucking                                         0.8          400 ! Add market value of equity + market value of debt                      ! If you compute unlevered beta with cash: 0.8(400/550) + 1.3(100/55
Software                                         1.3          100 ! All equity firm. So Equity = Firm                                      Wrong market value weights: - 1 point
Unlevered beta = 0.80 (400/500) + 1.30 (100/500) =                                                       0.90                              If you unlevered the beta of target firm (which is already unlevered):
c.
Market value of equity = 10*35 - 50 =                                                       300 ! Dividends paid reduces equity in firm
Market value of debt = 50+150 =                                                             200
new levered beta = 0.90 (1 + (1-.4) (200/300)) =                                           1.26               ! Wrong market value debt to equity ratio : -1 point

Quiz 1: Spring 2003

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Problem 1
a. Decrease stockholder power. While it may empower some stockholders (probably insiders), it will reduce to voting rights of stockholders in the aggregate.
b. Increase stockholder power. The voting rights on these treasury stock will no longer reside with management.
What makes treasury stock particularly damaging to stockholders is that managers use stockholder money to buy stock in the company and then proceed to vote the stock.
Even if they do not vote the stock, it becomes a very effective way of getting rid of troublesome stockholders.
c. Decrease stockholder power: Hostile acquisitions will become less likely, thus entrenching existing management,
d. Decrease stockholder power. Foreign institutional investors are less likely to be cowed by incumbent managers.
While I see some merit in the argument that local investors are more likely to be involved than foreign investors, note that domestic investors are
As a general rule, any restriction on investors buying stock or voting on them plays into the hands of incumbent management.
Domestic stockholders are made more powerful when they are backed up by foreign investors.

Problem 2a.
Monthly Jensen's alpha = 0.30% = 0.05% - Riskfree rate (1-2.00)                                                     Common Errors:
Monthly riskfree rate =                         0.25%                                                               1. Calculating Jensen's alpha wrong: -1 point
Annualized riskfree rate=                       3.04% ! 3% if you do not compound                                   2. Annualized incorrectly: - 0.5 point

Problem 2b.
Riskfree rate =                                    4.40% ! Riskfree rate in Euros                            ! Use of US T.Bond rate: - .5 point
4.53% ! European risk premium is over too short a period You cannot use the European historical premium since there are only 1
Euro Cost of Equity =                          13.4600% ! 4.40% + 2(4.53%)                                   ! The risk premium estimated in the US is the premium for a mature ma
! Use of wrong premium: -.5 point
Note: The fact that you are using a 10-year bond rate should be of no relevance in picking a risk premium. Therefore, the fact that the historical premium was computed over 10 yea
Problem 3
a. Bottom-up Levered beta
Unlevered beta for steel companies =                       1.1785714 ! =1.32/(1+(1-.4)(.20))
Unlevered beta for cash =                                            0 ! Total value of firm = Equity + Debt = 600+ 400 = 1000                      ! Forgot to weight cash: - 1 point
Unlevered beta for company =                               0.7071429 ! Cash is 400 million; Value of steel business = 1000 - 400 = 600              ! Wrong weights for cash and asset
Weights are 60% for steel and 40% for cash                                   ! Wrong unlevered beta: - .5 to -1

b. Market value of equity =                                                   600                                   ! Wrong debt to equity ratio: -.5 point
Market value of debt =                                                      400                                   ! Wrong beta used: -.5 point
Debt to Equity Ratio =                                                0.6666667
Levered Beta = 0.707 ( 1+ (1-.4) (.67)) =                                                   0.99

c. If the firm returns \$ 200 million as a special dividend and invests \$ 200 million in the chemical business with a beta of 0.70
Unlevered beta = 1.179 (.75) + 0.70 (.25) =                                1.0589286 ! Value of firm = 800; Steel stays at \$ 600 and chemical business is \$ 200
New Debt to Equity ratio = 400/400 =                                                 1 ! Equity will drop by 200 million; Debt stays at 400 million
New levered beta =                                                         1.6942857 ! 1.059*(1+(1-.4)(1)))

Quiz 1: Spring 2004
Problem 1
a. Maximize firm value: If markets are not efficient, you should not focus on stock prices. Since bondholders are not
protected, you should not maximize stockholder wealth.
b. An institutional investor, who is most likely to well diversified. In all the other cases, you are likely to find the marginal investor not well diversified.
c. A publicly traded firm that is widely held by institutions and managers hold little stock in the firm. (The conflict is likely to be smaller in a firm with activist investors and with the founder/owner as CEO becaus

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d. True. Badly managed firms whose stock has done badly are more likely to be targets in hostile takeovers.

Problem 2
a. Quarterly riskfree rate =                                   0.50% ! If you compound, the answer is            0.4963%
Jensen's alpha =                                              -1.15% ! Stock did 1.15% worse than expected each quarter
Annualized           -4.60% ! If you compound, the answer is              -4.52%

b. Expected Return = 4.25% -0.20 (4.82%) =                                                  3.29%

c. You would settle for less than the riskfree rate because it operates as insurance against inflation.

Problem 3
Step 1: Compute the unlevered betas
Unlevered beta for Greider =                                                       1 ! 1.30/(1+(1-.4)(200/400))
Unlevered beta for Motown Movies =                                               0.5 ! 1.40/(1+(1-.4)(300/100))
Unlevered beta for combined firm =                                               0.8 ! 1 (600/1000) + 0.5(400/1000)
Weights are values of the two firms (debt + equity)

Step 2: Compute the debt to equity ratio after the merger and new levered beta
Debt = 200 + 300 + 100 =                                                     600 ! Assume \$300 million in debt and borrow \$100 million to buy back stock
Equity =                                                                     400
New levered beta =                                                          1.52 ! 0.80 (1 + (1-.4) (600/400))

Part b
If equity issued and debt of Apple is retired:
Debt =                                                                          200                                                                                     ! I don't quite understand the solutions w
Equity = 400 + 400 =                                                            800 ! Firm has to issue 400 milliion in equity to retire debt and buy stock in Motown   in cash to retire the debt. If this cash wa
New levered beta =                                                             0.92 ! 0.80 (1+(1-.4)(200/800))                                                          your unlevered beta will have to be adju

Spring 2005
Problem 1
1a. Paying greenmail to a bidder to avoid a hostile acquisition.
All of the other actions can have reasonable explanations at least some of the time.

All of the other actions should make you more comfortable as a lender.

1c. False. It is only if earnings increases or decreases are greater than expected that you should see stock prices react.

1d. True. You don't need to assume that markets are efficient to maximize firm value. It is stock price maximization that requires this assumption.

Problem 2                                                                                                                                                               Errors
Expected Return = 4.25% + 1.60 (4.75%) =                                   11.85%                                                                                       1. Wrong riskfree rate: -1
* You have to use the current long term bond rate in the US (US \$ cost of equity)                                                                                       2. Wrong beta: -1
* You have to use the beta estimated against the S&P 500 (broad US index, since your investors are US diversified investors)                                            3. Wrong risk premium: -1
* You have to use long term risk premium (available only for the US)                                                                                                    (I know… I know…if you get all 3 w
Why is there no country risk premium?                                                                                                                                   still get a zero, not -1)

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1. The company gets 100% of its revenues from the US. There should be relatively little country risk exposure.
2. Even if you decided that there should be country risk exposure, there is not enough info to compute it. (You cannot compete a shekel rate to a \$ rate)

Problem 3
Unlevered beta =                                                1.4 ! Unlever using average D/E ratio over last 5 years                                                 Errors
Levered beta =                                                 1.96 ! Relever back up using current D/E ratio                                                           1. Used current D/E ratio to unleve
2. Used wrong D/E to relever beta:
New Balance Sheet after transaction                                                                                                                                     3. Mechanical errors: -1/2 each
Debt                                             150 Software              1000                 ! Equity after = 600 (Equity before) + 1000 (Windfall)
Equity                                          1350 Hardware               500                 ! - 250 (Dividends paid) = 1350                                         1.   Business mix weights wrong: -1
2.   Debt wrong: -1
New unlevered beta = 1.4 (1000/1500) + 1.1 (500/1500) =                                                   1.3                                                           3.   Equity wrong: -1
New levered beta = 1.3 (1+ (1-.4) (150/1350)) =                                     1.3866667                                                                           4.   Mechanical errors: -1/2 each

Spring 2007
Problem 1
a. Restricted stock in the company (restrictions are on trading)
Stock options are a close second but they may encourage too much risk taking
Bonuses tied to earnings or revenues may align with stock prices
b. Firms with better corporate governance are more likely to change managers when they are badly managed
Not all firms with good corporate governance are well managed and not all firms with poor corporate
governance are poorly managed, but good corporate governance allows stockholders to change bad
managers more easily.
c. Maximize stockholder wealth
You can still steal from your bondholders or create social costs in an efficient market
d. Convince customers to stop buying the firm’s products and investors to sell it’s stock
This may be my subjective judgment but laws and lawsuits are blunt weapons. For every guilty firm that
they target, they create significant costs for the non-guilty.
(If you can make a convincing case for one of the other options, I am willing to listen)

Problem 2
a. The broadest inext in terms of risky assets represented (to get close to the market portfolio in the CAPM)
b. Expected Return = Riskfree Rate + Beta * Risk Premium                                                                                               !0.5 point for wrong riskfree rate
= 4.75% + 0.80 (4.91%) =                           8.68%                                                      ! 0.5 point for error in calculation
c. Price today = \$ 40
Jensen's alpha (monthly) =                                                 0.21%                                                                                     ! 1 point for Jensen's alpha calculation
Jensen's alpha (annualized)                                                2.55% ! You got full credit if you used 2.52% - the non-compounded number                 ! 1 point for price calculation
Expected return next year =                                               11.23% ! Expected return (8.68%) + Jensen's alpha
Expected Stock price in 1 year =                                           \$44.49 ! 40 (1.1123)

Problem 3
a. Unlevered beta for combined compan                                                                                                      ! 1 point for unlevered betas of the two companies
Unlevered beta of acquirer =                                                 0.80                                                          ! 1 point for weighted average (right weights)
Unlevered beta of target =                                                   1.00
Unlevered beta for combined company =                                                      0.88 ! 0.8 (1500/2500) + 1.00 (1500/2500)
b. To get to a levered beta of 1.144, you can solve for the D/E ratio

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1.144 = 0.88 (1+(1-.4)(D/E))                                                                                             !1 point for solving for D/E ratio
D/E Ratio =                                  50.00%                                                                      !1 point for workng out dollar debt repaid
Total value of the firm afer transaction =                                        \$2,500
Debt after transaction =                                              \$833 ! (0.5/1.5) (2500)
Total assumed debt =                                                \$1,300
Debt retired =                                                        \$467

Spring 2008
a. Small board, composed mostly of outsiders, with an independent chairman                                              While I feel theat the outsiders/ independent chairman are p
Small boards are generally more effective than large boards, outsiders than insiders and an independent chairman helps. the small versus large board is more debatable. In a fit of g
I gave full credit for those who picked a large, outside. Inde
b. Looking for a friendly bidder (white knight) who will compete with the hostile acquirer.
If they succeed, you get an even higher price. If they fail, the hostile takeover still goes through.                   ! Every other choice here has negative consequences for yo

c. False.                                                                                                                ! I know that you feel aggrieved on this one, but this is not
It is only if you pay a premium over the true value of the acquirer that your stock price should drop.                   an inefficient market.
You alwayas pay more than the current price in an acquisition.
(I know that many you rationalized a "true" answer by arguing that the market price is right in an efficient market.
That is true, but only in reflecting the current value of the firm. To the extent that you can create synergy or other
potential value increase, you can pay more than the market price and still walk away a winner.)

d.                                                                                                                       Whilel stockholders collectively may be hurt, it is the stockh
Stockholders in potential targets. Stockholders in acquiring firms may actually be thankful and bondholders              potential takeover targets where the effect is going to be gr
generally are more likely to be hurt than helped by takeovers.

Problem 2
To get a nominal peso cost of equity                                                                                     Use of T.Bond rate as riskfree rate: -1 point
First, you need a riskfree rate in reais                                                                                 Use of the wrong beta: -1 point
Rate on 10-year nominal Pesobond =         11%                                                                           Estimated risk premium wrong: -0.5 to -1 point
- Default spread for bond               2.50% ! Both the dolalr and reai bonds have same rating.                        Mechanical errrors: -0.5 point
Riskfreee rate in nominal reais          8.50%   Used the spread from the dollar bond

Next, we need an equity risk premium
Equity risk premium for US              4.79% ! Since no risk premium was given, I used the historical US average
Total equity risk premium =           8.540%
Last, we need a beta
Since the marginal investors are globally diversified, we will use the MSCI beta of 0.90

16.19%
Cost of equity = 8.5% + 0.90 (8.54%) =

Problem 3                                                                                                                ! Did not adjust the regression beta at all: -1 point
Regression beta =                             1.20                                                                       ! Used the wrong weight on cash: -0.5 point
Unlevered beta for company =                  1.20 ! No leverage                                                         ! Multilplied instead of dividing by cash/value: -0.5 point

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20.00%
Proportiion of the company that is cash =
Proportiion that is soflware =        80.00%
Unlevered beta for software business = 1.50

b. Breakdown of value after acquisitiion         Weights    Unlevered beta                                                ! Forgot cash in computing unlevered beta: -1 point
Software                                     240    75.00%          1.5                                                   ! Used wrong weights on assets: -0.5 to -1 point
Cash                                          40    12.50%            0                                                   ! Used wrong debt to equity ratio: -0.5 to -1 point
Internet services                             40    12.50%            2 ! Use unlevered beta of business
320
Weighted unlevered beta =                  1.375
Debt/Equity after transaction             6.67% !Debt =20, Equity =300
Weighted levered beta =                     1.43

Spring 2009
Problem 1
a. iv. Top managers at badly managed companies will be fired more frequently.
b. iv. Not count unreturned proxies as votes (returned proxies will be counted)
There were some who "required all shareholders, by law, to return their proxies. First, I am not sure that you can force them to fill it out before they return. Second, what do you pla
c. ii. Require that all top management compensation contracts be put to shareholder vote (rather than be approved by the board of directors)
Many of you picked "requiring at least 50% of the compensation being options". Good soliution, but to the wrong problem. If the problem that you were trying to solve was that man
alighed with stockholder interests, this would work. However, the problem here is a different one. CEOs are being given large compensation packages by the board of directors in the
I don't see how requiring that 50% of that outlandish package be options will solve the problem. In fact, some of the most obscen pay packages in US corporate history have been co
d. ii. No. Even if markets are efficient, stock prices can be volatile.

Problem 2
0.15% - X (1-1.20) = 0.30% - X (1-0.90)
0.15%+0.2X = 0.30%-0.1X
0.3X=0.15%
X = 0.5%

b. Expected Return = 3% + 1.20 (6%) =                 10.20% ! Use long term riskfree rate

c.
Riskfree rate =                              3% ! US T.Bond rate (Mexican dollar bond rate is not riskless)

Mexican Country risk premium =               6% ! (Mexican default spread = 3%; Eequity risk premium = 2*3% = 6%)
Total Equity risk premium =                 12% ( Default spread: Mexican dollar bond rate - US treasury bond rate)

Cost of equity =                          13.80% ! 3% + 0.90 (12%)

Problem 3
a. Levered beta =                            1.2
Average D/E ratio over period=              50%
Tax rate =                                  40%

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Unlevered beta =                                   0.92

b. Unlevered beta for casinos =                   1.2
Unlevered beta for catering =              0.64615385 ! 0.92= 1.20 (0.5) + X (0.5)
(Weighted based upon values of businesses_

c. New weights                            New value  Weights     Unlevered beta
Casino                                            500 0.66666667          1.2
Catering                                          250 0.33333333 0.64615385
New unlevered beta =                                              1.01538462

New Debt =                                        150
New Equity                                        600                                                                           ! Used Debt/Capital instead of D/E: -0.5 points
New D/E ratio =                                  0.25
New levered beta =                         1.16769231 ! 1.0667* (1-(1-.40)(.25))

Spring 2010
Problem 1
a. Make this a freebie, since you can think of good reasons why this statement can be true or false.
To the extent that institutional investors own more stock, they have more weight to throw around (True)
The problem is that most instiutional investors are passive and vote with managers (false)
b. Activist investors target the company (The essence of a backlash is that life gets more unpleasant for managers. Investors selling
their stock clearly does not and giving managers options is a reward, not a backlash.)
c. No. If the expectation was for a much larger earnings increase, this could have been a negative surprise.
d. Foreign institutions. They own a lot of stock and trade the stock.

Problem 2
a. Riskfree rate = 3.5%                                                                                          ! Wrong riskfree rate = -1/2 point
Beta = 1.20 (investors are global investors)                                                                  ! Wrong beta = -1/2 point
Cost of equity = 3.5% + 1.2 (4.5%) =                                      8.90%

b. Riskfree rate = 3.5%
Beta = 1.20 (investors are still global investors)                                                            ! Wrong riskfree rate = -1/2 point
Country risk premium = 1.6* (6% - 3.5%) =                                               4.00%                 ! Wrong beta = -1/2 point (Even if you used the same beta in part a)
Total equity risk premium = 4.5% + 4.00% =                                              8.50%                 ! Wrong equity risk premium = -1 point
Cost of equity = 3.5% + 1.2 (8.5%)                                                     13.70%

Problem 3
a. Unlevered beta for the firm
Business                                  Weight          Unlevered beta                                         ! Wrong unlevered beta = -1 point
Software                                           60%             1.2                                           ! Wrong debt to equity ratio = -1 point
Consulting                                         40%             0.9                                           ! Math errors = -1/2 point
Firm                                                              1.08
Current financial balance sheet
Debt =                                              400                Software              1200 Debt                    400

Page 10
Corporate Finance

Equity =                    1600               Consulting              800 Equity                 1600
D/E Ratio                   0.25
Levered beta=              1.242

b. After restructuring
Business                         Weight     Unlevered beta                            ! Did not compute dollar effects of restructuring correctly = -1 point
Software                    600      37.50%           1.2                             ! Wrong unlevered beta = -1 point
Consulting                 1000      62.50%           0.9                             ! Wrong debt to equity ratio = -1 point
Firm                       1600                   1.0125
New financial balance sheet
Debt =                       400            Software               600 Debt                     400
Equity =                    1200            Consulting            1000 Equity                  1200
D/E Ratio                33.33%
Levered beta=              1.215

Page 11
Corporate Finance

geometric averate premium over T.Bonds for most cost of equity and expected return computatios

Page 12
Corporate Finance

Page 13
Corporate Finance

Page 14
Corporate Finance

though, you can make a good case for larger boards)

beta with cash: 0.8(400/550) + 1.3(100/550) + 0(50/550) =   0.81818182

f target firm (which is already unlevered): -1 point

Page 15
Corporate Finance

e aggregate.

hen proceed to vote the stock.

ors, note that domestic investors are not precluded from investing if foreing investors enter the market.

orical premium since there are only 10 years in the sample. The standard error will overwhelm the estimate.
US is the premium for a mature market. You can apply it to France and Germany.

premium was computed over 10 years is of little consequence.

! Forgot to weight cash: - 1 point
! Wrong weights for cash and assets: -1 point
! Wrong unlevered beta: - .5 to -1 point

! Did not adjust weights correctlyY: -.5 to -1 point
! Used beta from part a instead of unlevered beta of steel companies: -0.5 points
! Wrong debt to equity ratio: -0.5 points

nd with the founder/owner as CEO because stockhodlers will have a say in management).

Page 16
Corporate Finance

! I don't quite understand the solutions where you find \$ 300 million
in cash to retire the debt. If this cash was sitting around prior the acquisition,

1. Wrong riskfree rate: -1
2. Wrong beta: -1
(I know… I know…if you get all 3 wrong, you
still get a zero, not -1)

Page 17
Corporate Finance

1. Used current D/E ratio to unlever regression beta: -1
2. Used wrong D/E to relever beta: -1/2
3. Mechanical errors: -1/2 each

1.   Business mix weights wrong: -1
2.   Debt wrong: -1
3.   Equity wrong: -1
4.   Mechanical errors: -1/2 each

r wrong riskfree rate
r error in calculation

! 1 point for Jensen's alpha calculation
! 1 point for price calculation

as of the two companies
age (right weights)

Page 18
Corporate Finance

utsiders/ independent chairman are pretty clear
board is more debatable. In a fit of generosity,
ose who picked a large, outside. Independent chair as well

re has negative consequences for you as a stockholder

aggrieved on this one, but this is not evidence for

ectively may be hurt, it is the stockholders in firms that are
ets where the effect is going to be greatest.

iskfree rate: -1 point

m wrong: -0.5 to -1 point

ression beta at all: -1 point
ht on cash: -0.5 point
dividing by cash/value: -0.5 point

Page 19
Corporate Finance

ting unlevered beta: -1 point
on assets: -0.5 to -1 point
quity ratio: -0.5 to -1 point

they return. Second, what do you plan to do, if they do not?

ou were trying to solve was that management interests were not
kages by the board of directors in the face of poor performance.
in US corporate history have been construced using options.

Page 20

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