Is there a difference between investing in stocks and gambling

Is there a difference between investing in stocks and gambling

Subject: Business    / Finance
Question

1. Is there a difference between investing in stocks and gambling?

2. The CAPM states the covariance of an asset’s returns with the market returns is a better measure of risk than the asset’s variance. Brie?y explain why? Are there any conditions under which this result would not hold, i.e. what prominent assumption largely causes this result?

3. Say General Electric is thinking of spinning o? (loosely creating a separate company) its aircraft leasing business. You are thinking of buying stock in the new company and you want to estimate its beta. How might you do so?

4. Corporations used to form conglomerates (composite companies formed through the acquisition of smaller companies in often vastly di?erent businesses). Their justi?cation was often that conglomerates o?ered investors diversi?cation. Use an argument similar to the M&M arbitrage, which lead to M&M proposition I (no taxes), that the value of a conglomerate should be the sum of the values of the individual companies. Ignore any ‘synergies’ in the conglomerate, and focus only on the diversi?cation argument.

5. In a world with no corporate taxes, brie?y explain why a ?rm’s weighted average cost of capital stays constant while the amount of debt in the ?rm’s capital structure increases.

6. Should managers choose the capital structure which maximizes the value of the ?rm, or maximizes the value of the ?rm’s equity?

7. In a Modigliani and Miller world with taxes and bankruptcy costs, brie?y explain how we arrive at the optimal capital structure.

Computation

1. Using the CAPM. The risk-free rate of return is 4% and the expected return on the market is 8%. What is the expected rate of return on a stock with a beta coe?cient of 1.28?

2. A company has a target capital structure of 40% common stock and 60% debt. The company’s cost of equity is 12%, and its cost of debt is 7%. The tax rate is 35%. What is the company’s WACC?

3. A company has a WACC of 7%. The company’s cost of equity is 10% and its cost of debt is 5%. The tax rate is 35%. What is the company’s debt-equity ratio?

4. (MM with no taxes) Your company has no debt, and has an 8% WACC. If the current market value of your company’s equity is $150 million, and there are no taxes, what is EBIT?

5. M&M Proposition I with Corporate Taxes: A company is presently unlevered. It will generate $100 million in EBIT in perpetuity. The corporate tax rate is 35%, and all earnings after tax are paid out as dividends. The ?rm is considering a capital restructuring to allow $75 million of debt. Its cost of debt capital is 8%. Unlevered ?rms in the same industry have a cost of equity capital of 17%. What will be the new value of the company after the capital restructuring?

6. A company has an EBIT of $950,000 per year which is expected to continue in perpetuity (forever). The companys unlevered cost of equity is 10%, and the corporate tax rate is 35%. The company has a perpetual bond issue outstanding with a market value of $2.2 million. What is the value of the company?

7. A company has 100,000 shares of stock outstanding that sell for $100 per share. Assuming no market imperfections or tax e?ects exist, what will the share price be after:

(a) a 2-for-1 stock split (b) a 1-for-4 reverse stock split (c) a 30% stock dividend