Corporate Finance: Does the statement, “mutual fund X has had superior performance for each of the last 10 years” contradict the efficient market hypothesis?
Question 1:
Taxes are costs, and, therefore, changes in tax rates can affect consumer prices, project lives, and the value of existing firms. Evaluate the change in taxation on the valuation of the following project:
0 |
1 |
2 |
3 |
|
1.Initial Investment |
100 |
|||
2. Revenues |
100 |
100 |
100 |
|
3. Cash operating costs |
50 |
50 |
50 |
|
4. Tax depreciation |
33.33 |
33.33 |
33.33 |
|
5. Income pretax |
16.67 |
16.67 |
16.67 |
|
6. Tax at 40% |
6.67 |
6.67 |
6.67 |
|
7. Net income |
10 |
10 |
10 |
|
8. After-tax salvage |
15 |
|||
9. Cash flow (7+8+4-1) |
-100 |
43.33 |
43.33 |
58.33 |
NPV at 20%=0 |
Assumptions: Tax depreciation is straight-line over three years. Pre-tax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2. Tax on salvage value is 40% of the difference between salvage value and book value of the investment. The cost of capital is 20%.
a. Please verify that the information given above yields NPV = 0.
b. If you decide to terminate the project in year two (2) what would be the NPV of the project?
c. Suppose that the government now changes tax depreciation to allow a 100% write-off in year one (1). How does this affect your answers to parts a and b above?
d. Would it now make sense to terminate the project after two rather than three years?
e. How would your answers change if the corporate income tax were abolished entirely?
Question 2:
Please answer the following parts in detail, provide examples whenever applicable, provide in-text citations.
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State if each of the following statements is true or false. Justify your answers.
The efficient-market hypothesis assumes that
a. There are no taxes.
b. There is perfect foresight.
c. Successive price changes are independent.
d. Investors are irrational.
e. There are no transaction costs.
f. Forecasts are unbiased.
2. Evaluate each of the following statements:
a. “The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets.”
b. “If everyone believes you can make money by charting stock prices, then price changes won’t be random.”
c. “The random-walk theory implies that events are random, but many events are not random. If it rains today, there’s a fair bet that it will rain again tomorrow.”
3. Does the statement, “mutual fund X has had superior performance for each of the last 10 years” contradict the efficient market hypothesis?
a. If fund X is the only fund, calculate the probability that only by chance it would have achieved superior performance for each of the past 10 years.
b. Now recognize that there are nearly 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance?
4. Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes:
a. Investor to financial intermediary, to financial markets, and to the corporation.
b. Investor to financial markets, to a financial intermediary, and to the corporation.
c. Investor to financial markets, to a financial intermediary, back to financial markets, and to the corporation.
SAMPLE ASSIGNMENT
