第二次作业答案（1－4） Question １ Yes. The sale of the machine is part of the project initiative. Therefore, the proceeds from the sale of the equipment should be counted. No. The R&D expenditure is a sunk cost that should not be included in the project evaluation. Yes. This is an opportunity cost that is borne by the company. Yes. Capital expenditures must be incorporated in an NPV analysis. It is the depreciation tax shields that is the incremental cash flow and not the actual depreciation expense. It is the change in net working capital that is the incremental cash flow. Therefore, incremental cash flows are -$10 million at year 0, -$2 million at year 1, +$7 million at year 2 and +$5 million at year 3. No, dividend payments are not incremental cash flows. Question ２ Alternative One: Increases in annual profits: $50,000 (Cost Saving) ( $20,000 (Maintenance Cost) = $30,000 Annual net operating cash flows: $30,000 ( (1-0.35) + $60,000 ( 0.35 (dep. tax shields) = $40,500 At 10% discount rate, the project NPV:  The annualised capital cost (ACC) is given by  (  Alternative Two Increases in annual profits: $70,000 (Cost Saving) ( $15,000 (Maintenance Cost) = $55,000 Annual net operating cash flows (years 1 to 7): $55,000 ( (1-0.35) + ($600,000/7) ( 0.35 (dep. tax shields) = $65,750 The net cash flow for year 7: $65,750 + $60,000 ( (1 ( 0.35) = $104,750 At 10% discount rate, the project NPV:  The annualised capital cost (ACC) is given by  (  Decision: Alternative one should be chosen, as its annualised cost of capital is less. Question ３ The cash flows of the project can be summarised as follows: Year 0 Year 1 Year 2 Year 3 Year 4  Capital Investment (6,000,000)      Change in WC (150,000) (150,000) 0 0 300,000  Revenues  1,500,000 3,120,000 4,056,000 3,374,592  Cash Expenses Variable Costs Labour Costs   250,000 108,000  515,000 215,280  663,063 222,815  546,364 230,613  Depreciation  1,500,000 1,500,000 1,500,000 1,500,000  Pre-tax Profits  (358,000) 889,720 1,670,122 1,097,615  Taxes  (125,300)* 311,402 584,543 384,165  Net Op. Cash Flows  1,267,300 2,078,318 2,585,579 2,213,450  Net Cash Flows (6,150,000) 1,117,300 2,078,318 2,585,579 2,513,450   * Note: we assume that the company as a whole (inc. the cash flow from the project) will be profitable in year 1. Using the nominal discount rate of 12%, the project NPV is ($57,881. Question ４ Because we are considering company managers here, we are talking about strong form efficiency. Because the observation states that managers are successful in exploiting their (presumably) private information, it must be that their company's share price did not reflect the information when managers traded on it. Therefore, the observation is inconsistent with SFE. It may imply consistency with SSFE. Presumably the statement implies that managers use private information when trading in their own company and that share prices reflect this private information when it eventually becomes public. However, we can't say for sure whether it implies SSFE because we don't know anything about how quickly or correctly the market responded to the information when it became public. In general, inconsistency with SFE has no implications for either SSFE or WFE. Consistency with SFE in general, would imply both SSFE and WFE because these are weaker requirements. Existing evidence is inconclusive about whether corporate insiders earn abnormal returns from trading on their private information. Some recent evidence in the UK (Gregory, Matatako, Tonks, and Purkis, Economic Journal, January 1994), finds that neither directors themselves nor outside investors who attempt to mimic the trades of directors, earn high profits. (Outside investors mimic insiders by copying the trades of directors when these become public information. Companies have to notify details of these trades to the Stock Exchange who make the details publicly available-see, for example, Saturday's edition of the FT.) Previous evidence (Pope, Morris and Peel, Journal of Business Finance and Accounting, Summer 1990) found the market does react to information about dealing by `insiders'. That is, directors' buy/sell decisions are on average taken to be signals of good/bad news about the company and the market responds by bidding up/down the share price, ensuring corporate insiders earn profits. Pope et al. also found evidence that an uninformed investor could have earned abnormal returns by simply trading based on publicly available information about the dealings of corporate insiders. This suggests share prices do not react instantaneously to this publicly available information and the stock market is not fully SSFE with respect to this type of information signal. Inconsistent with WFE: it suggests changes in share price (or returns) are not independent. There has been renewed interest in recent years in share price patterns. Early research tended to support the hypothesis of WFE. One line of recent research (initiated by Fama and French, Journal of Political Economy, 1988, Journal of Financial Economics, 1989, and Poterba and Summers, Journal of Financial Economics, 1989) has exploited advances in statistics to look at returns for holding periods exceeding a year. A popular interpretation of this research is that it shows returns over long holding periods (more than a year) exhibit `negative autocorrelation'. If returns are negatively autocorrelated, low returns tend to follow high returns and vice versa. We call this pattern of predictability in share prices, `mean reversion'. Returns average out at some constant level so that a run of higher than average returns follows a run of lower than average returns and vice versa-average returns move back (revert) to the mean. Some academics argue that mean reversion provides proof that share prices deviate from fundamental values for reasonably long periods. However, two of the original authors (Fama and French) are careful to point out that the evidence is also consistent with market efficiency and changes over time in the returns expected on shares as the economy moves between recession and boom. Recent research (Kim, Nelson and Startz, Review of Economic Studies, 1991) finds evidence that the pre-War period drives the mean reversion results with persistence in returns (mean aversion) characterising the post-War period. There are two further strands of empirical literature looking at share price patterns. One of these suggests there is evidence of longer-term overreaction in share prices. Specifically, some evidence for the UK and the US suggests the following as a successful investment strategy: track share prices for a 3 to 5 year period; rank all stocks in order of their performance over this period; identify the top 30, or 50, or 10% of best performing stocks (past winners) and the corresponding worst performing stocks (past losers); buy the past losers and sell the past winners and maintain this strategy for a corresponding 3 to 5 year period. The second strand suggests there is evidence of short-term momentum (underreaction) in the UK and the US. The strategy suggested here is to identify past winners and losers over a 3 to 12 month period, to buy the winners and sell the losers and maintain this strategy for a corresponding 3 to 12 month period. For a recently published research study on the momentum effect in the UK, see Liu, W., N. Strong, and X. Xu. 1999. The profitability of momentum investing, Journal of Business Finance and Accounting, 26, (November/December), 1043-1091. Note that inconsistency with WFE must imply inconsistency with both SSFE and SFE. This is a loose statement of a statistical model known as a random walk. It implies that you can't predict next period's price change based on previous prices. The statement is consistent with weak-form efficiency, but says nothing about either SSFE or SFE. This statement may be entirely consistent with SSFE. First, in an efficient market, share prices respond only to surprises (news; new information). This means, for example, that share prices react only to unexpected earnings announcements (the difference between actual earnings and what the market expected earnings to be). Here, the market may have already `discounted' bad news about this company into the share price. Despite the announcement of a large fall in profits compared with last year, the actual profit figure may still have been above what the market was expecting. An example of this was the case of Amstrad in 1988 when there were dire warnings about the company's position (the failure of its latest generation of computers, EC measures to discourage manufacture outside the EEC, etc.) before the actual announcement of its earnings figure. (In addition there had been an announcement of unaudited half-year earnings figures in its interim report.) Because of this, Amstrad's share price fell well before the announcement of its final results and when it actually announced its results they turned out to be above market expectations although dramatically down on the previous year's figures. Second, there could be an abnormal increase in a company's share price in response to an unexpected fall in profits even when the market is reacting efficiently. For example, shortly before Ford acquired Jaguar, Jaguar's share price rose in response to a profit figure below market expectations. This occurred because it made a takeover bid for the company more likely (and so the anticipated bid premium reflected in Jaguar's share price increased). So, although we normally interpret an unexpected fall in earnings as `bad' news for a company and expect the result to be a fall in share price, the stock market can be more sophisticated in using information. This is a form of non-randomness (or regularity or pattern) in share prices that runs counter to the strict version of WFE. It has been found valid in several countries including the UK. However, empirical evidence shows it would not be possible to profit from a trading rule based on this effect because any gains in share price would be more than outweighed by transaction costs. Nevertheless, it is difficult to provide a rational explanation for the weekend effect. To the extent that it is inconsistent with WFE, it is also inconsistent with SSFE and SFE. This is exactly how you would expect a semi-strong efficient market to react to unexpected good news. However, with a single example, it is impossible to say whether a rise to 400 is appropriate. How the market reacts to unexpected earnings changes will depend whether it regards the change as permanent or temporary. Some earnings changes occur because of one-off events affecting earnings only for a single year. If earnings increases are temporary, or `transitory', earnings are expected to return to the previous level in the following year. Other earnings changes are permanent, in the sense that if earnings increase this year, then they are expected to stay at the increased level next year. Of course, some earnings changes may fall somewhere between transitory and permanent. An increase in earnings is more valuable if it signals a permanent change than if it signals a temporary change. In practice, earnings changes are likely to be partly permanent and partly transitory.