Solution to Problem Set 5

ECN 134
Financial Economics Prof. Farshid Mojaver
Questions on Stock Valuation 2
1. The market consensus is that Analog Electronic Corporation has an ROE=9%, has a
beta of 1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3.
This year’s earnings were $3 per share. The annual dividend was just paid. The
consensus estimate of the coming year’s market return is 14%, and T-bills currently
offer a 6% return.
a. Find the price at which analog stock should sell.
b. Calculate the P/E ratio.
c. Calculate the present value of growth opportunities.
d. Suppose your research convinces you Analog will announce momentarily that it
will immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the
stock. The market is still unaware of this decision. Explain why V0 no longer
equals P0 and why V0 is greater or less than P0 .

2. Peninsular Research is initiating coverage of a mature manufacturing industry. John

Jones, CFA, head of the research department, gathered the following fundamental
industry and market data to help in his analysis:
Forecast industry earnings retention rate 40%
Forecast industry return on equity 25%
Industry beta 1.2
Government bond yield 6%
Equity risk premium 5%
a. Compute the price-to-earnings (P0/E1) ratio for the industry based on this
fundamental data.
b. Jones wants to analyze how fundamental P/E ratios might differ among countries.
He gathered the following economic and market data.

Fundamental Factors Country A Country B

Forecasted growth in real GDP 5% 2%
Government bond yield 10% 6%
Equity risk premium 5% 4%
Determine whether each of these fundamental factors would cause P/E ratios to be
generally higher for Country A or higher for Country B.

3. The risk-free rate of return is 8%, the expected rate of return on the market portfolio
is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong
pays out 40% of its earnings in dividends, and the latest earnings announced were $10
per share. Dividends were just paid and are expected to be paid annually. You expect
that Xyrong will earn an ROE of 20% per year on all reinvested earnings forever.
a. What is the intrinsic value of a share of Xyrong stock?
b. If the market price of a share is currently $100, and you expect the market
price to be equal to the intrinsic value 1 year from now, what is your expected 1-
year holding-period return on Xyrong stock?
4. Janet Ludlow’s firm requires all its analysts to use a two-stage dividend discount
model (DDM) and the Capital Asset Pricing Model (CAPM) to value stocks. Using the
CAPM and DDM, Ludlow has valued QuickBrush Company at $63 per share. She
now must value SmileWhite Corporation.
a. Calculate the required rate of return for SmileWhite by using the
information in the following table.

QuickBrush SmileWhite
Beta 1.35 1.15
Market price $45.00 $30.00
Intrinsic value $63.00 ?

Notes:
Risk-free rate 4.50%
Expected market return 14.50%

b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:
First 3 years 12% per year
Years thereafter 9% per year

Estimate the intrinsic value of SmileWhite by using the table above, and the two-
stage DDM. Dividends per share in the most recent year were $1.72.
c. Recommended QuickBrush or SmileWhite stock for purchase by comparing each
company’s intrinsic value with its current market price.
d. Describe one strength of the two-stage DDM in comparison with the
constant-growth DDM. Describe one weakness inherent in all DDMs.

5. Abbey Naylor, CFA, has been directed by Carroll to determine the value of Sundanci's
stock using the free cash flow to equity model. Naylor believes that Sundanci's FCFE
will grow at 27 percent for two years and 13 percent thereafter. Capital expenditures,
depreciation, and working capital are all expected to increase proportionately with FCFE.

a. Calculate the amount of FCFE per share for the year 2008 using the
data above.
b. Calculate the current value of a share of Sundanci stock based on the
two-stage FCFE model. Show work.
c. i. Describe one limitation of the two-stage DDM model that is
addressed by using the two-stage FCFE model.
ii. Describe one limitation of the two-stage DDM model that is not addressed by
using the two-stage FCFE model.
Table A Sundanci actual 2007 and 2008 financial statement for fiscal years ending May
31 ($ million, except per share data)

6. Christie Johnson, CFA has been assigned to analyze Sundanci using the constant
dividend growth price/earnings (P/E) ratio model. Johnson assumes that Sundanci’s
earnings and dividends will grow at a constant rate of 13 percent.
a. Calculate the P/E ratio based on information in tables A and B and Johnson’s
assumptions for Sundanci.

b. Identify, within the context of the constant dividend growth model, how each of
the following factors would affect the P/E ratio.

• Risk (beta) of Sundanci

• Estimates growth rate of earnings and dividends

• Market risk premium

Table B Selected Financial Information on Sundanci

Holding Period Rate of Return
1-What was the beginning price of a stock if its ending price was $23, its cash dividend
was $1, and the holding period return on a stock was 20%?
A) $20 B) $24 C) $21 D) $18

2-You purchased 100 shares of stock for $25. One year later you received $2 cash
dividend and sold the shares for $22 each. Your holding-period return was ____.
A) 4% B) 8.33% C) 8% D) -4%

3-The geometric average of 10%, -20% and 10% is __________.

A) 0% B) 1.08% C) -1.08% D) -2%

4-An investor invests 80% of her funds in a risky asset with an expected rate of return of
12% and a standard deviation of 20% and 20% in a treasury bill that pays 3%. Her
portfolio's expected rate of return and standard deviation are __________ and
__________ respectively.
A) 12%, 20% B) 7.5%, 10% C) 9.6%, 10% D) 10.2%, 16%

5-Suppose stock ABC has an average return of 12% and a standard deviation of 20%.
Determine the range of returns that ABC's actual returns will fall within 95% of the time.
A) Between -28% and 52% B) Between -8% and 32%
C) Between 12% and 20% D) None of the above

6-What is the expected real rate of return on an investment that has expected nominal
return of 20%, assuming the expected rate of inflation to be 6%?
A) 14% B) 13.2% C) 20% D) 18.4%

7- What is the ending price of a stock if its beginning price was $30, its cash dividend
was $2, and the holding period return on a stock was 20%?
A) $32 B) $34 C) $36 D) $28

8- Historical returns have generally been __________ for stocks than for bonds.
A) the same B) lower C) higher D) none of the above

9- Geometric average returns are generally __________ arithmetic average returns.

A) the same as B) lower than C) higher than D) none of the above
Risk and Return
1. You consider investing in one of three portfolios X, Y, or Z, for one year. The following matrix
gives the means and standard deviations of annual returns in % for the three portfolios; annual
returns are distributed normally:
X Y Z
Mean 5 7 5
Std. Dev. 20 20 10

Rank the three portfolios in order of the probability of

i) the one-year return being negative,
ii) the one-year return being less than 5 %,
iii) the one-year return being less than 10 %.
(Hint) you do not need a table for the normal distribution to arrive at the correct answers
to i) through iii)
iv) Could you imagine a rational investor preferring X to Y?
v) Could you imagine a rational investor preferring X to Z?
vi) Could you imagine a risk-averse investor preferring X to Z?

2. Based on the scenarios below, what is the expected return for a portfolio with the
following return profile?
Market Condition
Bear Normal Bull
Probability 0.2 0.3 0.5
Rate of return -25% 10% 24%
Use the following scenario analysis for Stocks X and Y to answer Problems 3 through 5
(round to the nearest percent)
Normal
Bear Market Bull Market
Market
Probability 0.2 0.5 0.3
Stock X -20% 18% 50%
Stock Y -15% 20% 10%
3. What are the expected rates of return for Stocks X and Y?

4. What are the standard deviations of returns on Stocks X and Y?

5. Assume that of your $10,000 portfolio, you invest $9,000 in Stock X and $1,000 in Stock Y.
What is the expected return on your portfolio?

6. For the following, assume the annual returns on financial investments to be approximately
normally distributed.
a.Over the period from 1945-1992 (48 years), the annual return on corporate bonds had an
average of 6% and a standard deviation of 10%. In approximately how many years during
this period did an investment in corporate bonds lose money?
b.Over the same period, the annual return on the S&P 500 (a portfolio of the 500 largest
capitalization stocks) had an average of 11% and a standard deviation of 16%. During the
worst five of those years, the annual return was less than (approximately) X % ; X = ?