Lecture1 (1)

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Dr Thomai Filippeli Lecture 1

description

corporate finance

Transcript of Lecture1 (1)

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Dr Thomai Filippeli

Lecture 1

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Lecturer: ◦ Dr Thomai Filippeli◦ E – mail: ([email protected])◦ Room: W415◦ Office Hours: Friday 3pm – 5pm

Lectures:◦ 10x2 hours; Friday 12pm – 2pm, Fogg LT

Tutorials:◦ 10x1 hours

Assessment: ◦ Mid - term test (20%), Week 9, 27th of November◦ Final Exam (80%)

Lecture notes and tutorial questions can be downloaded from QM+.

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midterm includes content from (week 1-6)
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TextbookJonathan Berk and Peter DeMarzo, Corporate

Finance, global edition (3rd edition), Pearson, 2013

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Lecture notes

The lecture notes will be available on QMplus the

day before the lecture

Classes

On QMplus you will find the exercises for next

week

You are expected to solve the exercises BEFORE

each class

Model answers to the exercises will be available

on QMplus after the class

Class attendance is COMPLULSORY

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Berk and DeMarzo:

Chapter 1: The Corporation

Moles, Parrino and Kidwell:

Chapter 1: The Financial Manager and the

Firm

Chapter 2: The Financial Environment and

the Level of Interest Rates

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Basic principles of corporate finance

Four types of firms

Ownership versus Control of Corporations

Explain the role of the financial manager

Principal-agent problems

The stock markets

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It is the area of finance dealing with monetary decisions

that business enterprises make and the tools and

analysis used to make these decisions

Every decision made in a business has financial

implications, and any decision that involves the use of

money is a corporate financial decision.

Defined broadly, everything that a business does fit

under the rubric of corporate finance.

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Firm needs to raise (borrow) capital to finance its

investment and then pay its investors

There are many different ways to borrow money

(ie debt, equity) and to pay investors (ie coupons,

dividends, repurchases)

Modigliani and Miller: it is irrelevant how you raise

money and pay money

Deviations from M&M: taxes, bankruptcy costs,

agency costs, informational costs

Firms should look for cheapest way to do this

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They made this statement with the assumption that frictions do not exist
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however in the real world frictions do exist.
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1. The Investment Principle

It determines where the firms invest theirresources

2. The Financing Principle

It governs the mix of funding used to fundthese investments

3. The Dividend Principle

It answers the question of how much earningsshould be reinvested back into the businessand how much returned to the owner of thebusiness

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A firm is unprofitable when it fails to

generate sufficient cash flows.

Firms that are unprofitable over time will be

forced into bankruptcy by their creditors

In bankruptcy, the company will either be

reorganised or the company’s assets will be

liquidated.

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1.The capital budgeting decision: Which

productive assets should the firm buy?

A good capital budgeting decision is

one in which the benefits are worth

more for the firm than the cost of the

assets

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2.The financing decision: How should the firm

finance or pay for assets?

Financing decisions involve trade-offs

between advantages and disadvantages of

debt and equity financing.

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Working capital management decisions: How

should day-to-day financial matters be managed

The mismanagement of working capital can cause

the firm to go into bankruptcy even though the firm

is profitable.

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Working capital is the difference between the current assets and the current liabilities.
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The working capital tells us the firms liquidity and thus their ability to operate on a day to day basis.
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1. Sole Proprietorship

2. Partnership

3. Limited Liability Company

4. Corporation

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In a legal sense, it is a “person” distinct

from its owners.

The owners of a company are its

shareholders.

A major advantage of the corporate form

of business is that shareholders have

limited liability.

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Limited Liability - if the company goes bankrupt, the investor will only loose the amount of money they have originally invested.
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This feature is needed to attract investors, because it lowers the risk that they are exposed to, such as legal proceedings. Also, most people like to exert some control in decision making, however in large corporations we appoint managers, thus we lack this privilege. By having limited liabilities, we can remove some of investors concerns.
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The owners of companies are subject to

double taxation first at the corporate level

and then at the personal level when

dividends are paid to them.

Public companies can sell their debt or equity

in the public securities markets.

Private companies are held by a small

number of investors.

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s corporations - in order to be one the number of shareholders must be fewer than 100. This corporations do nnot pay taxes, the profits are directly sent to shareholders and they will pay taxes the one time.
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A set of projects which deliver future cash

flows (CF)

A firm is owned by investors with different

ownership rights or they own different pieces

of the firm.

Two major types of ownership: debt and

equity

How to become owner? Buy debt or equity

(lend money to the firm)

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The firm owns 100k barrel of oil today, it will

liquidate in one year

If price is $90/barrel, what is the liquidation value?$90 x 100k = $9M

This example: price December 2007

Price June 2008 : $140

Price July 2012: $91

Price oil changes means firm’s value changes : Risk for the

firm

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There is an outstanding zero coupon bond with

face value $5M. Zero coupon: one time payment (face value) at maturity

Key feature of bonds: It is a promised payment

debtor must pay (if debtor can pay) Therefore debt is senior to most other payments (equity)

Equity is junior, it is paid after debt is fully paid (voting rights)

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This is an agreement to pay the facevalue back at a certain date to the bond holder
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D=min(5M, 100k*P)

E=max(0,100K*P-5M)

What is the value of the debt and equity today?

If price is $40? $90? $140?

D=min(5M, 4M or 9M or 14M)=4M or 5M or 5M

E=max(0,4-5 or 9-5 or 14-5)=0 or 4M or 9M

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The debt holders will either get 5 million at maturity, or they will get the minimum of those two. They will either get all the assets of the firm if the 100k*P is less than the 5 million that is owed.
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At the maximum, the equity holders will get either zero or if they cant pay back the entire 5 million to bond holders, they will get the remaining value of the firm
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When the price is equal to p=40, the debtors will have to choose the minimum between 5 or 4 million. Thus they will get the 4 million.
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When the price is equal to p=90, the debtors will have to choose the minimum between 5 or 9 million. Thus they will get the 5 million.
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When the price is equal to p=140, the debtors will have to choose the minimum between 5 or 14 million. Thus they will get the 4 million.
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In the case P=$90 the total firm value is $9M, total

value of debt is $5M and total value of equity is

$4M.

4+5=9, E+D=V

If I would have set the face value to be any other

number we would have found the same thing: E

and D would change but E+D = 9 would not

change

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The total value of the firm is equal to the equity + debt.
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*face value of debt to be
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Regardless of the value of debt or equity, the value of the firm will not change. It is solely dependent on the price.
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M&M says it does not matter how we split

up the financing needs of the firm, the total

firm value remains unchanged if certain

assumptions hold.

What do we need to add/change in the

above calculation so that M&M no longer

holds?

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one example is if we add taxes For example, if we make the assumptions that the equity payouts are taxed but not the debt payouts then miller and modigliani assumption does not hold. Hence it makes a difference to the firm if it is going to hold more debt and less equity.. There are other factors that may affect the firms decisions, such as asymmetric information
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Suppose that equity payouts are taxed but not the

debt payouts.

Then we would want as much debt as possible

Other reasons: Agency costs, Distress costs,

Asymmetric Information

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Key feature: since debt payments are promised

(along with other payments such as salaries) they

must be payout before equity

Equity is the residual of what is left in the firm after

all promised payments paid out.

Equity payments are directly tied to firm’s

performance

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the better the performance, the better the return.
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Absolute Priority: Laws about which

claimholders are paid out first, equity is

last

Limited liability: Equity owners will get no

less than zero, they cannot be responsible

for the firm’s debts

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Common Shares: 80% of all equity, voting

rights, these are the owners of the firm

Preferred Shares: seniority over common

shares in payouts, dividends

predetermined at time of sale

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Firm consists of several projects worth $100M

Firm has 10M shares outstanding valued at $10

per share

Firm wants to raise $20M in cash, to do this it will

sell shares at price P

What is the number of shares sold? What is the

total value of the firm after the transaction?

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an example, of the main topics that corporate finance deals with.
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assets | liabilities cash 20 million equity 20 million
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This depends on the price of the share
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Number of shares sold: N=20/P

Total firm value after shares sold is the old firm

value (100) plus the infusion of cash (20) 100+20

= 120

Total shares outstanding: 10+N = 10 +(20/P)

Post – SEO (Secondary Equity Offerings) price

per share is the firm value divided by total shares

outstanding:

V = 120/(10+(20/P)) = 12/(1+(2/P))

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20 in millions
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SEO - when a firm issues new shares
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this should really represent the price per share
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If P=9, post-SEO price is 9.82. Are the new

shareholders happy? Are the old shareholders

happy?

If P=11, post-SEO price is P=10.15. Are the new

shareholders happy? Are the old shareholders

happy?

The only fair price is 10!

What if new shareholders didn’t know the true

value of the firm? What if old shareholders could

artificially inflate it?

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Yes, they paid only 9 for the share. Yet they are now worth 9.82.
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no, they paid 10 for their shares. However now the value has fallen to 9.82.
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12/(1+(2/9))
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12/(1+(2/11))
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no, they paid 11 for their shares. However now the value has fallen to 10.15.
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Yes, they paid only 10 for the share. Yet they are now worth 10.15.
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These are issues of asymmetric information, the old share holders have more information regarding the true value of the firm. They know that if they inflate the value of the firm and they sell at a higher price to the new share holders (less informed), they can sell at a very high price and benefit from an overall increase price to their shares.
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Corporate Management Team

◦ In a corporation, ownership and direct control are

typically separate.

◦ Board of Directors

Elected by shareholders

Have ultimate decision-making authority

◦ Chief Executive Officer (CEO)

Board typically delegates day-to-day decision making

to CEO.

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Ultimate management responsibility and

decision-making power in the firm.

Reports directly to the board of directors,

which is accountable to the company’s

owners.

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Responsible for the best possible financial

analysis that is presented to the CEO.

Positions that report to the CFO:

The chief accountant prepares financial

statements, oversees the firm’s cost accounting

systems, prepares taxes and works closely with

the firm’s external auditors.

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Financial Manager

◦ Responsible for:

Investment Decisions

Financing Decisions

Cash Management

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What Should Management Maximise?

Minimising risk or maximising profits

without regard to the other is not a

successful strategy.

Why not maximise profits?

With creative accounting the firm

can manipulate the profit figures.

Accounting profits are not

necessarily the same as cash

flows.

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Profit maximisation does not tell

us when cash flows are to be

received.

Why not maximise profits?

Profit maximisation ignores the

uncertainty or risk associated with

cash flows.

What Should Management Maximise?

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Maximise the Value of the Firm’s Share Price

When analysts and investors determine

the value of a firm’s shares, they

consider:

The size of the expected cash flows.

The mechanism for determining share

prices overcomes all the cash-flow

objections raised.

The timing of the cash flows.

The riskiness of the cash flows.

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An appropriate goal for financial

management is to maximise the current

value of the firm’s shares.

For private companies and partnerships,

the goal is to maximise the current value

of owner’s equity.

Maximise the Value of the Firm’s Share Price

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Can Management Decisions Affect Share

Prices?

YES!!!

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If a CEO is capable, he can adjust to the economic shocks and sometimes even predict them.
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Goal of the Firm

◦ Shareholders will agree that they are

better off if management makes

decisions that maximizes the value of

their shares.

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The Firm and Society

◦ Often, a corporation’s decisions that increase the value

of the firm’s equity benefit society as a whole.

◦ As long as nobody else is made worse off by a

corporation’s decisions, increasing the value of the

firm’s equity is good for society.

◦ It becomes a problem when increasing the value of the

firm’s equity comes at the expense of others.

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This is the pareto optimal state.
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Ethics and Incentives within Corporations

◦ Agency Problems

Managers may act in their own interest rather than in

the best interest of the shareholders.

One potential solution is to tie management’s

compensation to firm performance.

How should performance be measured?

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Ownership and Control

For large companies, the ownership of the

firm is spread over huge number of

shareholders and the firm’s owners may

effectively have little control over

management .

Management may make decisions that

benefit their self-interest rather than those of

the shareholders.

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Agency Relationships

An agency relationship arises whenever one party, called the principal, hires another party, called the agent.

The relationship between shareholders (principals) and management (agents) is an agency relationship.

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Do Managers Really Want to Maximise the Share Price?

Shareholders own the company but managers control the money and have the opportunity to use it for their own benefit.

Agency Costs

The costs of the conflict of interest between

the firm’s owners and its management.

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CEO Performance

◦ If a CEO is performing poorly, shareholders can

express their dissatisfaction by selling their shares.

This selling pressure will drive the stock price down.

◦ Hostile Takeover

Low stock prices may entice a Corporate Raider to

buy enough stock so they have enough control to

replace current management. The stock price will

rise after the new management team “fixes” the

company.

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The stock market provides liquidity

to shareholders.

◦ Liquidity

The ability to easily sell an asset for close to the

price you can currently buy it for

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Public Company

◦ Stock is traded by the public on a stock exchange.

Private Company

◦ Stock may be traded privately

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Primary Markets

◦ When a corporation itself issues new shares of stock

and sells them to investors, they do so on the primary

market.

Secondary Markets

◦ After the initial transaction in the primary market, the

shares continue to trade in a secondary market

between investors.

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Largest Stock Markets

◦ New York Stock Exchange (NYSE)

Market Makers/Specialists

Each stock has only one market maker

◦ NASDAQ

Does not meet in a physical location

May have many market makers for a single stock

◦ Bid Price versus Ask Price

Bid-Ask Spread

Transaction cost

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ASK PRICE - PRICE WE HAVE TO PAY FOR A SHARE BID PRICE - WHAT WE CAN SELL OUR SHARE FOR
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Source: www.world-exchanges.org

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You own 100 shares in a corporation. The corporationearns $5.00 per share before taxes. Once thecorporation has paid any corporate taxes that are due,it will distribute the rest of its earnings to itsshareholders in the form of a dividend. If the corporatetax rate is 40% and your personal tax rate on (bothdividend and non-dividend) income is 30%, then howmuch money is left for you after all taxes have beenpaid?

A) $210

B) $300

C) $350

D) $500

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$5(1-0.4) = $3 $3(1-0.3) = $2.10 $2.10*100=$210
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You own 100 shares of a subchapter "S" Corporation. The

corporation earns $5.00 per share before taxes. Once the

corporation has paid any corporate taxes that are due, it

will distribute the rest of its earnings to its shareholders in

the form of a dividend. If the corporate tax rate is 40% and

your personal tax rate on (both dividend and non-dividend)

income is 30%, then how much money is left for you after

all taxes have been paid?

A) $210

B) $300

C) $350

D) $500

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$5(1-0.3)=$3.50 $3.50*100 = $350
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they pay no corporate taxes.
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You are a shareholder in a corporation. This corporation

earns $4 per share before taxes. After it has paid taxes, it

will distribute the remainder of its earnings to you as a

dividend. The dividend is income to you, so you will then

pay taxes on these earnings. The corporate tax rate is

35% and your tax rate on dividend income is 15%. The

effective tax rate on your share of the corporations

earnings is closest to:

A) 15%

B) 35%

C) 45%

D) 50%

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corporate tax = 0.35*4 = $1.4 shareholders pay = $2.6*0.15 = $0.39 ET = ($1.4+$0.39)/$4 = 0.4475 Effective Tax = 45%
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You overhear your manager saying that she plans

to book an Ocean-view room on her upcoming trip

to Miami for a meeting. You know that the interior

rooms are much less expensive, but that your

manager is traveling at the company's expense.

This use of additional funds comes about as a result

of:

A) an agency problem

B) an adverse selection problem

C) a moral hazard

D) a publicity problem

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She makes this decision out off her own self interest, regardless of any concerns for the company she works for.
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Consider the following two quotes for XYZ stock:

November 11th November 18th

Ask: 25.25 Ask: 26.00

Bid: 25.20 Bid: 25.93

How much would you have to pay to purchase 100

shares of XYZ stock on November 18th?

A) $2520

B) $2525

C) $2593

D) $2600

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$26*100=$2600
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How much would you receive if you sold 200 shares

of XYZ stock on November 11th?

A) $5050

B) $5040

C) $5186

D) $5200

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$25.20*200=$5040