Cecchetti 6e Chapter08 SM

Chapter 08 - Stocks, Stock Markets, and Market Efficiency
Chapter 8
Stocks, Stock Markets, and Market Efficiency
Conceptual and Analytical Problems
1. Explain why being a residual claimant makes stock ownership risky. (LO1)
Answer: Stockholders do not receive dividends unless all of the firm’s creditors have
been paid. If the firm does poorly, stockholders may receive nothing. The result is
that returns to stockholders have high variance. In the event that the firm goes
bankrupt, stockholders lose their entire investment.
2. Do individual shareholders have an effective say in corporate governance matters?

(LO1)
Answer: In principle, shareholders have a say on corporate affairs. They elect

members of the company’s board of directors and can vote on important issues raised
at the company’s annual meeting. Furthermore, they can offer resolutions to be voted
on at the annual meeting. However, individual shareholders usually have one vote for
each share owned. With large companies having millions of shares outstanding, the
impact of a small shareholder is limited. In addition, while shareholders vote to elect
directors, managers, rather than owners, often control the overall board.
3. Consider the following information on the stock market in a small economy. (LO2)
Company Shares Price, Price, end

Outstanding beginning of year
of year
1 100 $100 $94
2 1,000 $20 $25
3 10,000 $3 $6
a. Compute a price-weighted stock price index for the beginning of the year and the
end of the year. What is the percentage change?
b. Compute a value-weighted stock price index for the beginning of the year and the
end of the year. What is the percentage change?
Answer:
a. For a price-weighted index, we find the cost of buying one share of each company
at the beginning of the year is $123 = $100 + $20 + $3. The cost of buying one
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share of each at the end of the year is $125 = $94 + $25 + $6. So the percentage
change is 1.6%.
b. The percentage change in a value-weighted index is given by percentage change

in the sum of the values of the companies. At the beginning of the year, the value
of the companies is given by $60,000 = $100(100) + $20(1,000) + $3(10,000).
At the end of the year, the value is $94,400 = $94(100) + $25(1,000) + $6(10,000)
So, the percentage change is 57.3%.
4. To raise wealth and stimulate private spending, suppose the central bank lowers
interest rates, making stock market investment relatively attractive. Which stock
market index would you monitor to judge the effectiveness of the policy: the Dow
Jones Industrial Average or the S&P 500? Why? (LO2)
Answer: Since the S&P 500 is a value-weighted index, it tracks the value of owning
each of the companies in the index. Thus, it is a measure of stock market wealth. The
DJIA, in contrast, is a price-weighted index that sums the cost of a single share of
each of the stocks in the index. As such, it does not measure wealth.
5. Suppose you see evidence that the stock market is efficient. Would that make you
more or less likely to invest in stocks for your 401(k) retirement plan when you get
your first job? (LO4)
Answer: Efficient markets suggest that all relevant information is incorporated into
stock prices, and that changes in prices on a particular day reflect that day’s “news.”
In this view, prediction of stock prices into the future is equivalent to trying to
forecast generally unknowable events. Your decision to invest in equities for
retirement likely is based on other information, like your attitude toward risk and
knowledge of the historical long-run performance of a diversified portfolio of stocks.
6. Professor Siegel argues that investing in stocks for retirement may be less risky than
investing in bonds. Would you recommend this approach to an individual in his or her
early 60s? (LO4)
Answer: The closer an individual is to retirement, the less time is available for a
portfolio to overcome downward shocks to its value. Consequently. allocating
retirement funds to a stock portfolio is riskier for a 60-year old than for a 25-year old.
Investment advisors often suggest that those close to retirement lower the fraction of
their savings exposed to equities.
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7. How do venture capital firms, which specialize in identifying and financing

promising but high-risk businesses, help the economy grow? (LO5)
Answer: New companies often have difficulty finding financing to put their plans
into action. Venture capital firms specialize (say, in one particular industry) in
identifying promising firms and providing early-stage funding. As a result, companies
with productive uses of funds that could not get start-up loans from traditional
intermediaries may succeed in bringing their good or service to the economic
marketplace. The resulting shift of resources to more productive activities boosts
incomes and economic growth.
8. *What are the advantages of holding stock in a company versus holding bonds issued
by the same company? (LO1)
Answer: Stocks represent a share of ownership in the company and give the holder a
share in the future profits of the company. If the company, for example, makes a great
discovery, invents the next great product, etc., stock holders get to participate in those
gains, whereas a bond holder receives only the coupon payments and principal
associated with the bond regardless. The potential upside is unlimited while, like
bond holders, the potential loss is limited to the initial investment made in the
company. The right to vote at annual meetings is another advantage of holding stock
rather than bonds in a company.
9. If Professor Siegel is correct that stocks are less risky than bonds, then the risk
premium on stock may be zero. Assuming that the risk-free interest rate is 2½
percent, the growth rate of dividends is 1 percent and the current level of dividends is
$70, use the dividend-discount model to compute the level of the S&P 500 that is
warranted by the fundamentals. Compare the result to the current S&P 500 level, and
comment on it. (LO4)
Answer:
If the current dividend is $70, the risk-free rate is 2.5 percent and the growth rate of
dividends is 1 percent, the value of the S&P 500 index warranted by fundamentals
is: P = $70(1.01) / (0.025 – 0.01) = $4,713.33
On April 22, 2019, the S&P 500 was at 2,933.68. This suggests that either the equity
risk premium is positive, or, if it is zero, that the stocks in the index are undervalued..
10. *Why is a booming stock market not always a good thing for the economy? (LO5)
Answer: If stock prices are rising for reasons that are not related to economic
fundamentals, there may be a misallocation of resources in the economy. Companies
invest in projects that may not be the most productive and do not add to economic
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growth. As investors’ wealth increases, they change their consumption patterns,

leading to increased demand for certain goods and services that cannot be sustained
when the stock market readjusts.
11. The financial press tends to become excited when the Dow Jones Industrial Average
rises or falls sharply. After a particularly steep rise or fall, media outlets may publish
tables ranking the day’s results with other large advances or declines. What do you
think of such reporting? If you were asked to construct a table of the best and worst
days in stock market history, how would you do it, and why? (LO2)
Answer: This type of reporting can be misleading because it ignores the level of the
index itself. A 100-point rise or fall means one thing when an index is at 5000, but
quite something else when it is at 10,000. Expressing performance as percentage
changes is the best solution.
12. You are thinking about investing in stock in a company which paid a dividend of $10
this year and whose dividends you expect to grow at 4 percent a year. The risk free
rate is 3 percent and you require a risk premium of 5 percent. If the price of the stock
in the market is $200 a share, should you buy it? (LO3)
Answer: Yes. Using the dividend discount model, you are willing to pay: P =
10(1.04)/(0.08 –.04) = $260 per share. Note that i is calculated by combining the
risk-free rate and the risk premium." As the asking price in the market is below this,
you should buy the stock.
13. *Suppose you use the dividend discount model to calculate the price you are willing
to pay for a stock and find that this differs from the market price. What might account
for the difference in the market price of the stock and the price you are willing to pay
for the stock? (LO3)
Answer: If, for example, the market price were below the price you are willing to pay
for the stock, the difference could reflect the fact that you require a lower risk
premium than the market in general or that you think that dividends for this company
are going to grow faster than the market in general. It could also reflect market
pessimism, pushing the price below the fundamental value.
14. You are trying to decide whether to buy stock in Company X or Company Y. Both
companies need $1,000 capital investment and will earn $200 in good years (with
probability 0.5) and $60 in bad years. The only difference between the companies is
that Company X is planning to raise all of the $1,000 needed by issuing equity while
Company Y plans to finance $500 through equity and $500 through bonds on which
10% interest must be paid.
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Construct a table showing the expected value and standard deviation of the equity
return for each of the companies. (You could use Table 8.3 as a guide.) Based on
this table, in which company would you buy stock? Explain your choice. (LO3)
Answer:
% % Required Pay to Equity Expected Standard

Equity Bonds Payment equity return Value of Deviation
on holders Equity of Equity
Bonds Return Return
Co. 100 0 0 60-200 6-20% 13% 7%
X
Co. 50 50 50 10-150 2-30% 16% 14%
Y
(Remember, for Company Y, the expected value of the equity return is calculated as a
% of 500 —the amount put into equity.)
Which company you choose depends on your attitude toward risk. If you are willing
to take on extra risk by buying stock in Company Y, you get a higher expected return.
If you are more risk averse, you may want to opt for the lower —but safer —return of
company X.
15. Your brother has a $1,000 and a one-year investment horizon and asks your advice
about whether he should invest in a particular company’s stock. What information
would you suggest he analyze when making his decision? Is there an alternative
investment strategy to gain exposure to the stock market you might suggest he
consider? (LO4)
Answer: You should explain that the return on his investment will depend on the
dividend he may be paid and the movement in the stock price over the year. You
could show him how to use the dividend discount model to assess whether the stock
is he considering is over- or under-valued relative to fundamentals to help predict his
chances of making a capital gain. You should mention that stocks are a relatively
risky investment over a short-run investment horizon. You could suggest that he
invest his $1000 in a mutual fund or exchange-traded fund, thus spreading the risk
over a portfolio of stocks.
16. Given that many stock market indices across the world fell and rose together during
the financial crisis of 2007-2009, do you think investing in global stock markets is an
effective way to reduce risk? Why or why not? (LO2)
Answer: While it is true that movements in stock market indices across the world
have become more highly correlated over time, as long as they are not perfectly
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correlated, there are benefits from spreading your investments. (Recall how
spreading reduces risk from chapter 5.)
17. Do you think a proposal to abolish limited liability for stockholders would be
supported by companies issuing stock? (LO1)
Answer: No. The obvious downside would be that stocks would become much less
attractive as an investment, making it much costlier for firms to raise funds by issuing
stock. The potential benefit would be that bondholders and creditors might find the
company more attractive, as in the event of bankruptcy they could pursue
stockholders for what they are owed. Practically speaking, however, this is unlikely
to be a feasible option.
18. You peruse the available records of some public figures in your area and notice that
they persistently gain higher returns on their stock portfolios than the market average.
As a believer in efficient markets, what explanation for these rates of returns seems
most likely to you? (LO5)
Answer: Your first instinct is that the public officials have access to inside
information, which they use to guide their investment decisions. Other possibilities
are that these public figures have simply been lucky or that they have a higher than
average appetite for riskier investments that have being doing well.
19. Do you think that widespread belief in the efficient markets theory was a significant
contributor to the 2007-2009 financial crisis? Why or why not? (LO5)
Answer: The efficient market hypothesis does not postulate that market prices of
securities are always correct, but that they reflect all known information that impact
their value. The crisis emerged as it became evident that relevant information was
incomplete or incorrect, leading to large price movements as investors reassessed the
risks associated with certain securities.
20. Based on the dividend-discount model, what do you think would happen to stock
prices if there were an increase in the perceived riskiness of bonds? (LO3)
Answer: If investors perceive bonds are more risky, then the relative riskiness of
stocks will fall. Stocks would become relatively more attractive, requiring a smaller
risk premium than before. From the dividend discount model, we can see that a fall
in the risk premium (which is in the denominator) would lead to a rise in stock prices.
21. *Use the dividend-discount model to explain why an increase in stock prices is often
a good indication that the economy is expected to do well. (LO3)
8-6
Answer: How well investors expect the economy to do is reflected in the expected
growth rate of dividends, g. When investors are optimistic about the future, they will
expect dividends to grow at a faster rate, which increases the price they are willing to
pay for stocks. From the dividend discount formula for the stock price, we can see
that g enters the numerator positively and the denominator negatively, so if g
increases, the stock price increases.
22. Memories of the 2007-2009 financial crisis have made you more risk averse,
doubling the risk premium you require to purchase a stock. Suppose that your risk
premium before the crisis was 4 percent and that you had been willing to pay $412 for
a stock with a dividend payment of $10 and expected dividend growth of 3 percent.
Using the dividend discount model, with unchanged risk-free rate, dividend payment
and expected dividend growth, what price (rounded to the nearest dollar) would you
now be willing to pay for this stock? (LO3)
Answer: First, use the dividend discount model formula to calculate the risk-free
interest rate.
Ptoday = Dtoday (1 + g)/(rf + rp – g)

$412 = 10(1.03)/(rf + 0.04 – 0.03)
This gives rf = 0.015, or 1.5%
Using this information, calculate the price you would be willing to pay with rp =
0.08.
Ptoday= 10(1.03)/(0.015 + 0.08 – 0.03) = $158.4615 = $158
23. Suppose a shock to the financial system were to disproportionately hit corporate bond
markets, making it much harder for companies to raise new funds via bond issuance.
As a result, the proportion of equity financing rises significantly. What impact would
you anticipate this would have on i) the expected return on holding stocks and ii) the
volatility of equity returns? (LO3)
Answer:
i) As the proportion of a company’s financing via equity versus debt rises, the
company’s leverage falls. While this shift reduces the expected return to equity
holders, it also reduces the standard deviation of equity returns.
ii) The decline in volatility of equity returns reflects the residual claimant status of
stockholders. With a smaller proportion of bondholders to be paid ahead of equity
holders, the standard deviation of equity returns is lower.
24. *The growth of private equity markets in the United States expands the options
available to firms to raise funds, as well as the investment choices available to
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some investors. Why do you think private equity investing tends to be confined to
institutional investors and high net worth individuals? ( LO4)
Answer: Private equity is not subject to the same regulatory requirements as

public issues, including requirements about the disclosure of information.
According to Core Principle 3, information is the basis for decisions, and large,
sophisticated investors would be in a much stronger position to acquire the needed
information and bear the costs of doing so. Private equity investments would also
be less liquid than publicly listed stocks, likely reducing their appeal for smaller
investors. Moreover, private equity markets are often chosen as a route to raise
funds for start-up ventures whose capital tends to be difficult to value, adding to
the riskiness of these investments. In addition, often small firms' goals are to
merge with larger companies rather than to remain independent, as an IPO would
require.
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Cecchetti 6e Chapter08 SM

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Chapter 08 - Stocks, Stock Markets, and Market Efficiency

Conceptual and Analytical Problems

2. Do individual shareholders have an effective say in corporate governance matters?

Answer: In principle, shareholders have a say on corporate affairs. They elect

Company Shares Price, Price, end

b. The percentage change in a value-weighted index is given by percentage change

7. How do venture capital firms, which specialize in identifying and financing

growth. As investors’ wealth increases, they change their consumption patterns,

% % Required Pay to Equity Expected Standard

Ptoday = Dtoday (1 + g)/(rf + rp – g)

Ptoday= 10(1.03)/(0.015 + 0.08 – 0.03) = $158.4615 = $158

Answer: Private equity is not subject to the same regulatory requirements as

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