Finance Market Efficiency and Capital Budgeting

FNCE 370v8: Assignment 4

Assignment 4 is worth 5% of your final mark. Complete and submit Assignment 4 after you complete Lesson 12.

There are 12 questions in this assignment. The break-down of marks for each question is presented in the table below. Please show all your work as this will help the marker give you part marks as well as serve as a good study aid as you prepare for the Final Examination.

Question Marks Available Reference

1 5 Lesson 10

2 5 Lesson 10

3 5 Lesson 10

4 5 Lesson 10

5 10 Lesson 11

6 15 Lesson 11

7 10 Lesson 11

8 10 Lesson 11

9 5 Lesson 12

10 10 Lesson 12

11 10 Lesson 12

12 10 Lesson 12

Total 100

1. Explain the interactions among market efficiency, capital budgeting, and the cost of capital. (5 marks)

In order to make good capital budgeting decisions the manager should use a correct cost of capital which is determined by the use of funds. The NPV in an efficient market will be zero which indicates that managers should explore positive NPV projects to to determine the cshflow estimate and the source of value. When the market is efficient the cost of capital in the market is a good estimate of the return required.

(5 marks)

a. Give two examples of anomalies in the financial markets.

Seasonality of stock prices (January Effect) which is when firms with small capitalizations have high returns in the first days of the new year so investors buy small capitalizations stocks in December.

Bubble theory of speculative markets: Prices move very rapidly above their true value.

b. What does the existence of these anomalies say about financial market efficiency?

Anomalies show financial market inefficiency

2. You bought one of BB Co.’s 9% coupon bonds one year ago for $1020. These bonds make annual payments and mature six years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 10%. If the inflation rate was 4.2% over the past year, what would...