Corporate Finance 6232 – Prof.

Fox – 04F Final

Exam ID Number __________

December 14, 2004

2 ½ hours

CORPORATE FINANCE 6232

FINAL EXAMINATION

Fall 2004 PROF. MERRITT B. FOX

The exam has 10 questions. Answer all of them. Each has the number of points
indicated, 98 in total. You get two points for handing in your exam. You will have 2 ½ hours to
complete the exam.

This is an open book exam. You may use the texts and photocopied materials, all
handouts, your notes, and notes and outlines developed by other members of the class. You may
use a calculator if that is helpful. Include units (e.g., dollars, percent) in your answers where that
is appropriate.

If you think a question is ambiguous, explain why and make whatever assumptions you
think are necessary to resolve the ambiguity. Do not strain, however, to find ambiguities that
then permit assumptions that undercut what the question appears to be trying to get at.

Please return this exam packet with your number on it.

(1) ANSWERS MAY BE TYPED ON A COMPUTER OR WRITTEN IN BLUE BOOKS,

BUT YOU MUST CHOOSE ONE OR THE OTHER (NOT BOTH). (You may use
whatever other paper you have for notes, including this exam packet.)

(2) PLEASE START YOUR ANSWER TO EACH OF THE 10 QUESTIONS ON A

SEPARATE PAGE.

(3) AT THE TOP OF THE FIRST PAGE OF THE ANSWER TO EACH QUESTION,
PUT A HEADING GIVING YOUR EXAM ID NUMBER, THE QUESTION YOU ARE
ANSWERING, AND HOW MANY PAGES THERE ARE IN THAT ANSWER. (For
example: 11978 Q6 2pp) WRITE YOUR EXAM ID NUMBER ON EVERY PAGE.

(4) THE QUESTIONS WILL BE READ SEPARATELY, AND SO, DO NOT REFER IN
ANY ONE ANSWER TO WHAT YOU HAVE SAID IN ANY OTHER ANSWER.

There will be a small penalty each time you fail to comply with any of these
requirements.

PLEASE OBSERVE THE MAXIMUM WORD LIMITS.

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TRUE/FALSE/UNCERTAIN QUESTIONS

Each of questions 1-6 has a “true”/“false”/“uncertain” format. At the beginning of your

answer to each, explicitly state whether the statement in bold type is true, false, or uncertain, then
explain your answer fully. Confine each answer, however, to a maximum of 100 words. Each
question is worth 7 points. Assume for each of these six questions that CAPM and the
semistrong version of the efficient market hypothesis correctly describes market pricing.

For these six questions, credit will be determined exclusively by your explanation. No
credit will be given for simply stating “true,” “false,” or “uncertain,” even if your response
is correct. No credit will be given for a correct response if only accompanied by an
incorrect or irrelevant explanation.

**********

1. In a semi-strong efficient capital market, a well-diversified portfolio of common

stocks is a positive net present value investment opportunity, even for uninformed
investors.

2. For complicated tax reasons, Z corporation wishes to repurchase from its top executives
previously issued nontransferable stock options. The options have an exercise price of
$32.50 and mature in seven years. There are no market traded options in shares of Z with
anything approaching comparable terms or maturity. Share price is currently $82.50 but
it has been very volatile over the years. The risk free rate of interest is 7%. Z proposes to
repurchase these options for $64.00 each. A shareholder files a derivative suit alleging
waste that is based on the claim that the $64.00 price is grossly in excess of the value of
these options. Z files for summary judgment arguing that the shareholder claim is “too
improbable to merit continuation of the suit.” Z is correct that it is very unlikely that
$64.00 is more than what the options are worth.

3. In undertaking an event study, one often cannot be sure that all the information
concerning the event becomes public on a single day. Furthermore, market participants
may need time for reflection in order to most accurately assess an event’s significance.
To ascertain whether an event was viewed by the market as positive or negative, it is
therefore best to employ a cumulative abnormal return (CAR) approach with a
window period extending from the earliest date that any information concerning the
event could possibly have been received by anyone participating in the market to a
date sufficiently after the last piece of such information could possibly have become
fully public that it would be fully reflected upon.

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4. A sudden increase in the interest rate is a mixed blessing for the holders of currently
outstanding U.S. Treasury bonds. On the one hand, they are hurt by suffering a
capital loss as a result of the rate increase. On the other hand, they are helped by
the increase in the yield on their bonds.

5. You are at a bar and overhear two executives of ABC, a large corporation whose shares
actively trade on the New York Stock Exchange. The executives are talking about some
confidential things relating to their corporation. You gather that the corporation is going
to announce some big news next week that is going to cause a lot of excitement in the
market. You have absolutely no idea, however, whether the news is good or bad since the
roar of the crowd watching the hockey game on the bar’s large screen TV drowned out
that part of the conversation. Assume you have no moral scruples about trying to make
money on the basis of overhearing such a conversation and that there is no legal obstacle
to your doing so. Nevertheless, there is no way you can make money on the basis of
what you overheard.

6. You can choose to invest your total wealth in one of two portfolios, X or Y and in
nothing else. Each is composed of securities bought and sold in an efficient market and
each costs exactly your total wealth to acquire. Each has the same beta. You will be
indifferent between the two portfolios and hence it would be rational to choose
between them by flipping a coin.

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 Corporate Finance 6232 – Prof. Fox – 04F Final

ESSAY QUESTIONS

7. (14 points, 200 words maximum) Mr. White purchased shares of the XYZ corporation
on May 1, shortly after it announced that it was planning soon to introduce a new kind of
small radio that only needs a change of batteries once every five years. Except for this
extraordinary battery life, the new kind of radio performs no better than its $30
competitors, a fact which is understood by the market. The May 1 announcement does
not include the planned price of the new radio. On May 15, Mr. White still owns the
shares, and XYZ puts the radios on sale, announcing, shortly before the opening of the
stock market, that due to the very high cost of manufacture, the price of the new radio is
$300.

XYZ’s share price drops on May 15 from $50 to $46.00. Mr. White sues XYZ, claiming
that the failure on May 1 to announce that the price of the radio was going to be so high
was a material omission that made the May 1 product announcement misleading in
violation of the Exchange Act’s Rule 10b-5. Assume that the rule of thumb in securities
law is that where negative information that is omitted reveals that the actual value of the
firm is lowered by 5% or more, it is material, and otherwise it is not.

As evidence of the materiality of the omission, Mr. White introduces at trial an event
study that shows a market adjusted drop in price of $3.50 on May 15. There was no other
dramatic news relating to XYZ that came out on May 15. The standard deviation for
daily market adjusted price changes of XYZ stock is $1.00.

What are the arguments pro and con that with the event study, Mr. White has established
by the preponderance of the evidence that the omission was material?

8. (14 points, 200 words maximum) The facts are the same as in question 7, except as
follows. The event study shows that the market-adjusted share price drop on May 15 was
only $.50. Again, there was no other dramatic news relating to XYZ that came out on
May 15. This time the event study is introduced by the defendant, XYZ, in connection
with a motion for summary judgment based on the claim that the omission was not
material and therefore did not violate the securities laws. In support of his opposition to
XYZ’s summary judgment motion, Mr. White introduces an affidavit from a marketing
expert who opines that despite the advantage of no battery change for five years, almost
no one would pay $300 for a radio that otherwise does not outperform a $30 competitor.

What are the arguments pro and con that based on the event study, XYZ’s motion for
summary judgment should be granted because there is no genuine issue of fact as to the
immateriality of the omission.

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 Corporate Finance 6232 – Prof. Fox – 04F Final

9. (14 points, 150 words maximum). Imagine that (i) $60 is the current market price of a
share of ABC stock, (ii) $16 is the current market price of a call on ABC stock
exercisable in one year at an exercise price of $55, (iii) the risk free rate of interest is
10%. Assume no transactions costs and that investors can borrow and lend at the risk
free rate.

(a) Under these circumstances, what would be the equilibrium market price of a put on
ABC stock exercisable in one year at an exercise price of $55?

(b) Why would a put price higher than your answer in (a) be a disequilibrium price, i.e.,
what would happen in the market such that this higher price would not be stable?

(c) Why would a put price lower than your answer in (a) be a disequilibrium price, i.e.,
what would happen in the market such that this lower price would not be stable?

10. (14 points, 200 words maximum) One of the chapters in the great book of financial
scandals of 2002 involves analysts. Consider this fictionalized story patterned after one
of these true life scandals. Between January 1, 1999 and April 1, 1999, Henry Blockhead,
who was employed by the ML brokerage firm, made several highly positive public
statements (including a “strong buy” recommendation) concerning the stock of EFG, Inc.,
which was traded on the New York Stock Exchange (the NYSE) and produced medical
devices that allow the home care of patients who previously would have required
hospitalization. Blockhead did not have access to private inside information from EFG
and the public did not believe that he did. Rather, he claimed that his announced
conclusion that EFG was very underpriced was based on his analysis of the future market
for EFG’s products, its costs of manufacturing as revealed in its SEC filings, and EFG’s
recent success in enlarging its market share. Private memos from Blockhead to others at
ML, however, indicated that Blockhead did not in fact believe that the stock was
underpriced. Indeed in one memo, he referred to EFG as “a dog of a company.” The real
reason Blockhead made his public recommendations was to help ML get investment
banking business from EFG. ML’s investment bankers hoped to earn fees by arranging
for loans of money to EFG through private placements to insurance companies. EFG’s
stock rose steadily from January 1 to April 1, 1999, but collapsed after an early April
announcement of a sharp sales reversal. At the time of the sales reversal announcement,
Blockhead took EFG off his “strong buy” list. EFG’s share price has not recovered since.
EFG did not offer any new stock during the January 1 to April 1 period.

Blockhead and ML are sued in a class action naming as plaintiffs everyone who
purchased EFG stock on the NYSE between January 1 and April 1, 1999, the period in
which Blockhead was pushing the stock. The claim is that Blockhead made knowingly
false statements which had the effect of inflating the price EFG stock during this period
thereby damaging the plaintiffs by causing them to pay more for their shares than would
have been the case but for the false statements. The plaintiffs offer no empirical studies

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 Corporate Finance 6232 – Prof. Fox – 04F Final

to prove that the statements made EFG’s share price higher than it would otherwise have
been, but the statements were self evidently very positive and Blockhead was one of the
best known analysts on Wall Street.

(a) Imagine that you represent Blockhead and ML. Use concepts covered in this course
to argue that a key premise of the class action — that Blockhead’s statements inflated
the price of EFG stock — is not plausible as a matter of broadly held learning in
financial economics.

(b) Imagine that you represent the class. Use concepts covered in this course to argue
that this key premise is plausible as a matter of broadly held learning in financial
economics.

***END OF EXAM***

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