Suppose that price per share of NewOrange is currently $40, and normal risk adjusted monthly rate of
return for NewOragne's equity is 3%.
Suppose that the current price is efficient. Compute the expected price per share in one
)= $40*(1+0.03) = $41.2
Now suppose that you read in the Wall Street Journal that NewOrange is a target of a
pending takeover by a larger competitor. The takeover is expected to take place. It is
expected that the acquirer will pay a $10-per-share premium over the market price of the
target at the time of the takeover.
Compute the expected monthly rate of return on NewOrange's equity if the current market
price remains $40
)= $41.2+$10 = $51.2
E( r) = ($51.2 - $40)/ $40 = 28%
The expected return is greater than the 3% normal return. The asset offers abnormal return.
Suppose that market is efficient. Find new current market share price of NewOrange
($51.2 - P
) / P
How fast must the share price adjust in order to remain efficient? Briefly describe
mechanism of the adjustment
The price must adjust very quickly. The price is moved by the profit -seeking investors
(arbitrageurs) who buy shares of NewOrange to capture abnormal returns.
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