Chapter 13

Question 1

What are corporations?

Answer 1

A way of organising people to produce goods and services

Question 2

3 features of a corporation?

Answer 2

• owners not necessarily managers (executive members are both managers and owners)
• can be closely held (family) or widely (public)
• limited liability (unlike partnerships)

Question 3

What does limited liability mean?

Answer 3

Investors can only lose what they invest, done to encourage investment

Question 4

See rest of L1 intro stuff

Answer 4

now

Question 5

See example at top of CH13 notes

Answer 5

now

Question 6

Explain the difference between financing and investment decisions?

Answer 6

Investment decisions are simpler (F decisions have lots of different strategies), F decisions are easier

Question 7

Why are financing decisions easier? (2)

Answer 7

• Less degree of finality (easier to reverse)

- Difficult to make money by F strategies due to higher competitiveness tf not looking for a positive NPV

Question 8

Explain why markets are considered efficient?

Answer 8

Prices of stocks appear to follow a random walk (ie. successive changes in value are independent) tf odds of going up or down are the same day-day

Question 9

Why is there no day-day trend in stock markets?

Answer 9

As soon as cycles/trends are recognised by investors, they buy(/sell) until the price is pushed up(/down) tf eliminating the trend, tf stock once again offers normal risk-adjusted rate of return

Question 10

What would happen if past prices -> prediction of future prices?

Answer 10

->easy profits which can’t happen in a competitive market tf ALL (not just price) info will be reflected in today’s prices, not tomorrow’s tf RW tf market efficiency

Question 11

What is weak market efficiency and what is its implication?

Answer 11

When prices reflect information contained in record of past prices
Makes it impossible to make consistent SNP (RW)

Question 12

What is semistrong market efficiency and what is its implication?

Answer 12

Prices reflect not only all info in past prices, but also all other public information
Prices respond immediately to the release of public information (eg. merger proposal)

Question 13

What is strong market efficiency and what is its implication?

Answer 13

Prices reflect all info regarding analysis of company, economy etc (public +private info)
Will find lucky and unlucky investors but no one who can consistently profit off market

Question 14

Read iii top of page 1 side 2

Answer 14

shows need to account for market movements

Question 15

What does figure 13.4 show regarding takeover announcements?

Answer 15

Shows stock price jumps on day of announcement then is normal again
May drift up before if investors are expecting a takeover

Question 16

Define takeover premium?

Answer 16

The difference between the estimated real value of a a company and the price paid to acquire it

Question 17

How often according to 13.5 do mutual funds beat the markets?

Answer 17

Roughly 40% of the time

Question 18

Define risk adjusted return?

Answer 18

Measure of an investment’s return by measuring how much risk is involved

Question 19

In an efficient market what is it not possible to do? What does this mean for securities?

Answer 19

Not possible to find EXPECTED returns greater (or less) than the risk-adjusted opportunity cost of capital. This means securities trade at their fundamental value, based on future cash flows (C(t)) and opportunity cost of capital (r)

Question 20

2 pieces of evidence against market efficiency?

Answer 20

1) Earnings announcement puzzle

2) New issue puzzle

Question 21

Explain what the earnings announcement puzzle is?

Answer 21

Looking at stock performance from 1972-2001, top 10% of firms with best news on earnings only outperform those with the worst news by about 1%/month. This implies the market is ‘slow’ to react and tf takes time for investors to be fully aware of the significance (?)

Question 22

Explain what the new issue puzzle is?

Answer 22

IPOs often see buyers get an immediate capital gain, however these often don’t hold up in the LR

Question 23

What is the constant-growth formula used for?

Answer 23

Checking if shares are fairly valued

Shows that a small reduction in growth rate of dividends can lead to a large reduction in the present value of stocks

Question 24

What are bubbles?

Answer 24

When speculative frenzies from investors -> asset prices reaching levels that cannot be easily explained by the outlook for profits and dividends

Question 25

2 examples of asset price bubbles?

Answer 25

Japanese bubble dot.com boom Check I can briefly explain both of them

Question 26

Fundamentally, why do stock prices deviate from fundamental values?

Answer 26

People are 100% rational 100% of the time

Question 27

Why aren't people are 100% rational 100% of the time? (2 and explained)

Answer 27

1) Attitudes towards risk: eg. some investors may looks at past losses/gains and allow them to affect their decisions (wrongly) 2) Beliefs about probabilities: eg. investors may make errors in assessing probability theory such as putting more weight on recent events rather than treating all equally

Question 28

Define arbitrage?

Answer 28

A strategy that exploits market inefficiency and generates superior returns if and when prices return to fundamental values

Question 29

Risk of arbitrage?

Answer 29

Prices may diverge even further before converging tf -> firing of those investing in it or value of companies falling to bankruptcy levels

Question 30

What are the first 3 lessons of market efficiency, explained? (Apply to efficient markets)

Answer 30

1) Markets have no memory (Weak form hypothesis shows sequence of past prices contains no info on future prices) 2) Trust market prices (Prices can be trusted since they compound ALL available info) 3) Read the entrails (Bing able to read bond/stock prices can teach us a lot about the firm) (ie. bonds trading at low prices imply firm is in trouble)

Question 31

What are the second 3 lessons of market efficiency, explained? (Apply to efficient markets)

Answer 31

4) There are no financial illusions (Investors are only concerned with the firm's cash flows and how much they are entitled to) 5) The do-it-yourself alternative In an efficient market investors will not pay others for what they can do themselves (eg. they aren't interested in a merger -> a diversified firm if they can just buy the stock of both firms anyway) 6) Seen one stock, seen them all (Stocks don't have 'unique qualities', they only have fair returns for their risk tf almost perfect subs. (tf almost perfectly elastic demand))