Homework 2

(Due day is April 8th)

1. Debt issued by Southeastern Corporation currently yields 12%. A municipal bond of equal risk currently yields 8%. At what marginal tax rate would an investor be indifferent between these two bonds?

2. At your favorite bond store, Bonds-R-Us, you see the following prices:

One-year $100 zero-coupon selling for $90.19

Two-year 10% coupon $1,000 par bond selling for $1,000

Three-year 10% coupon $1,000 par bond selling for $1,000

Assume that the expectations theory for the term structure of interest rates holds, no liquidity premium exists, and the bonds are equally risky. What is the three-year rate from now?

3. Suppose that a share of Microsoft had a closing price yesterday of $90, but new information was announced after the market closed that caused a revision in the forecast of the price for next year to go to $120. If the annual equilibrium return on Microsoft is 15%, what does the efficient market hypothesis indicate the price will go to today when the market opens? (Assume that Microsoft pays no dividends.)

4. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding. Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split? If the actual market price immediately following the split is $17.00 per share, what does this tell us about market efficiency?

5. You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $24,000. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay? Why? How can this be resolved in a competitive market?

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6. You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend partially on how hard Ricky works, as follows.

If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity. However, Ricky would view working hard as a personal cost valued at $1,000. What fixed percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected payment less any personal cost.

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