4. Question 4 (efficient market hypothesis). Recall that if markets are efficient, all price changes must be exactly justified by changes in fundamental value. Suppose a company makes and sells bottles. The company can manufacture a million bottles every year (same number each year) at the cost of $6/bottle and sell them at the price of $10/bottle. Suppose there is no other cost, no taxes, and bottle prices never change, and that the company can always sell all the bottles it manufactures. Thus, the company makes $4 million profits each year. Further 7 assume the company always pay out profits as dividends to shareholders. Suddenly, the company experienced a surprising technology breakthrough which lowered the bottle production cost to $2/bottle. Assume this is the only change that 6 Make the strongest statement possible. For instance, suppose both the semi-strong and the strong forms are violated, then state that the semi-strong form is violated, because violating the former implies violating the latter. 7 Per bottle profit is $10 - $6 = $4. Because the company sells 1 million bottles, total profit is $4 x 1 million = $4 million. 8 What is the value of the company's stock? Well, stock holders receive $4 million in dividends each year. A common way to calculate the value of a stream of cash flows is to perform a "discounted cash flow valuation. For instance, suppose discount rate is r = 10%. Then, the value of the stock (the claim to all $4 future dividends) is 140 + 0 + ... = $1 10%= $40 million. The exact valuation formula does not matter. The key is that the stock value is proportional to the annual dividend payment. 1+ 4 happened. When this news was announced, the company's stock price immediately jumped up by 50%. Does the market appear efficient? Why or why not? Make sure to back up your answer with calculations. 4. Question 4 (efficient market hypothesis). Recall that if markets are efficient, all price changes must be exactly justified by changes in fundamental value. Suppose a company makes and sells bottles. The company can manufacture a million bottles every year (same number each year) at the cost of $6/bottle and sell them at the price of $10/bottle. Suppose there is no other cost, no taxes, and bottle prices never change, and that the company can always sell all the bottles it manufactures. Thus, the company makes $4 million profits each year. Further 7 assume the company always pay out profits as dividends to shareholders. Suddenly, the company experienced a surprising technology breakthrough which lowered the bottle production cost to $2/bottle. Assume this is the only change that 6 Make the strongest statement possible. For instance, suppose both the semi-strong and the strong forms are violated, then state that the semi-strong form is violated, because violating the former implies violating the latter. 7 Per bottle profit is $10 - $6 = $4. Because the company sells 1 million bottles, total profit is $4 x 1 million = $4 million. 8 What is the value of the company's stock? Well, stock holders receive $4 million in dividends each year. A common way to calculate the value of a stream of cash flows is to perform a "discounted cash flow valuation. For instance, suppose discount rate is r = 10%. Then, the value of the stock (the claim to all $4 future dividends) is 140 + 0 + ... = $1 10%= $40 million. The exact valuation formula does not matter. The key is that the stock value is proportional to the annual dividend payment. 1+ 4 happened. When this news was announced, the company's stock price immediately jumped up by 50%. Does the market appear efficient? Why or why not? Make sure to back up your answer with calculations