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CHAPTER13CORPORATEFINANCINGDECISIONSANDEFFICIENTCAPITALMARKETSAnswerstoConceptsReviewandCriticalThinkingQuestions1.Tocreatevalue,firmsshouldacceptfinancingproposalswithpositivenetpresentvalues.Firmscancreatevaluablefinancingopportunitiesinthreeways:1)Foolinvestors.Afirmcanissueacomplexsecuritytoreceivemorethanthefairmarketvalue.Financialmanagersattempttopackagesecuritiestoreceivethegreatestvalue.2)Reducecostsorincreasesubsidies.Afirmcanpackagesecuritiestoreducetaxes.Suchasecuritywillincreasethevalueofthefirm.Inaddition,financingtechniquesinvolvemanycosts,suchasaccountants,lawyers,andinvestmentbankers.Packagingsecuritiesinawaytoreducethesecostswillalsoincreasethevalueofthefirm.3)Createanewsecurity.Apreviouslyunsatisfiedinvestormaypayextraforaspecializedsecuritycateringtohisorherneeds.Corporationsgainfromdevelopinguniquesecuritiesbyissuingthesesecuritiesatpremiumprices.2.Thethreeformsoftheefficientmarketshypothesisare:1)Weakform.Marketpricesreflectinformationcontainedinhistoricalprices.Investorsareunabletoearnabnormalreturnsusinghistoricalpricestopredictfuturepricemovements.2)Semi-strongform.Inadditiontohistoricaldata,marketpricesreflectallpublicly-availableinformation.Investorswithinsider,orprivateinformation,areabletoearnabnormalreturns.3)Strongform.Marketpricesreflectallinformation,publicorprivate.Investorsareunabletoearnabnormalreturnsusinginsiderinformationorhistoricalpricestopredictfuturepricemovements.3.a.False.Marketefficiencyimpliesthatpricesreflectallavailableinformation,butitdoesnotimplycertainknowledge.Manypiecesofinformationthatareavailableandreflectedinpricesarefairlyuncertain.Efficiencyofmarketsdoesnoteliminatethatuncertaintyandthereforedoesnotimplyperfectforecastingability.b.True.Marketefficiencyexistswhenpricesreflectallavailableinformation.Tobeefficientintheweakform,themarketmustincorporateallhistoricaldataintoprices.Underthesemi-strongformofthehypothesis,themarketincorporatesallpublicly-availableinformationinadditiontothehistoricaldata.Instrongformefficientmarkets,pricesreflectallpubliclyandprivatelyavailableinformation.c.False.Marketefficiencyimpliesthatmarketparticipantsarerational.Rationalpeoplewillimmediatelyactuponnewinformationandwillbidpricesupordowntoreflectthatinformation.d.False.Inefficientmarkets,pricesreflectallavailableinformation.Thus,priceswillfluctuatewhenevernewinformationbecomesavailable.e.True.Competitionamonginvestorsresultsintherapidtransmissionofnewmarketinformation.Inefficientmarkets,pricesimmediatelyreflectnewinformationasinvestorsbidthestockpriceupordown.B-2SOLUTIONS4.Onaverage,theonlyreturnthatisearnedistherequiredreturn—investorsbuyassetswithreturnsinexcessoftherequiredreturn(positiveNPV),biddingupthepriceandthuscausingthereturntofalltotherequiredreturn(zeroNPV);investorssellassetswithreturnslessthantherequiredreturn(negativeNPV),drivingthepricelowerandthuscausingthereturntorisetotherequiredreturn(zeroNPV).5.Themarketisnotweakformefficient.6.Yes,historicalinformationisalsopublicinformation;weakformefficiencyisasubsetofsemi-strongformefficiency.7.Ignoringtradingcosts,onaverage,suchinvestorsmerelyearnwhatthemarketoffers;thetradesallhavezeroNPV.Iftradingcostsexist,thentheseinvestorslosebytheamountofthecosts.8.Unlikegambling,thestockmarketisapositivesumgame;everybodycanwin.Also,speculatorsprovideliquiditytomarketsandthushelptopromoteefficiency.9.TheEMHonlysays,withintheboundsofincreasinglystrongassumptionsabouttheinformationprocessingofinvestors,thatassetsarefairlypriced.Animplicationofthisisthat,onaverage,thetypicalmarketparticipantcannotearnexcessiveprofitsfromaparticulartradingstrategy.However,thatdoesnotmeanthatafewparticularinvestorscannotoutperformthemarketoveraparticularinvestmenthorizon.Certaininvestorswhodowellforaperiodoftimegetalotofattentionfromthefinancialpress,butthescoresofinvestorswhodonotdowelloverthesameperiodoftimegenerallygetconsiderablylessattentionfromthefinancialpress.10.a.Ifthemarketisnotweakformefficient,thenthisinformationcouldbeactedonandaprofitearnedfromfollowingthepricetrend.Under(2),(3),and(4),thisinformationisfullyimpoundedinthecurrentpriceandnoabnormalprofitopportunityexists.b.Under(2),ifthemarketisnotsemi-strongformefficient,thenthisinformationcouldbeusedtobuythestock“cheap”beforetherestofthemarketdiscoversthefinancialstatementanomaly.Since(2)isstrongerthan(1),bothimplythataprofitopportunityexists;under(3)and(4),thisinformationisfullyimpoundedinthecurrentpriceandnoprofitopportunityexists.c.Under(3),ifthemarketisnotstrongformefficient,thenthisinformationcouldbeusedasaprofitabletradingstrategy,bynotingthebuyingactivityoftheinsidersasasignalthatthestockisunderpricedorthatgoodnewsisimminent.Since(1)and(2)areweakerthan(3),allthreeimplythataprofitopportunityexists.Under(4),thisinformationdoesnotsignalanyprofitopportunityfortraders;anypertinentinformationthemanager-insidersmayhaveisfullyreflectedinthecurrentshareprice.11.Atechnicalanalystwouldarguethatthemarketisnotefficient.Sinceatechnicalanalystexaminespastprices,themarketcannotbeweakformef