ECN 134Questions on Stock Valuation 2Questions on Stock Valuation 3Solution to Problem Set 5ECN 134Financial Economics Prof. Farshid MojaverOn Financial Crisis1- What is a speculative bubble, give a few historical example, how do they happen?2- What was the role of deregulation in the financial crisis of 2008? 3- What is systemic risk? How did it happen during the financial crisis of 20084- How are MBS, CDO’s and CDS related to the recent financial crisis in US5- Why housing prices increased so dramatically from 2001 to 2004? 6- Why Warren Buffett called Credit Default Swaps financial weapons of mass destruction. Watch the following link to answer question (3) http://www.khanacademy.org/science/core-finance/derivative-securities/credit-default-swaps-tut/v/financial-weapons-of-mass-destructionQuestions on Stock Valuation 2Q1. Gruber Corp. pays a constant $12 dividend on its stock. The company will maintain this dividend for the next eight years and will then cease paying dividends forever. If the required return on this stock is 10%, what is the current share price? Kissling Corp. pays a constant $9 dividend on its stock. The company will maintain this dividend for the next eight years and will then cease paying dividends forever. If the required return on this stock is 11 percent, what is the current share price?P0 = $9.00(PVIFA11%,8) = $46.32Q2. XYZ company is currently restructuring. As a result, the market expects zero dividends for the following three years; from year 4 on, when the restructuring is expected to have been successfully completed, constant dividends of $ 8 per share are expected forever. Assume that- the applicable discount rate for holding XYZ stock (XYZ’s “required rate of return”, as we call it) is 16%- the market price for XYZ stock is and will be “fair”, that is: equal to the present valueof dividends, and that the future evolves exactly according to expectations;- XYZ stock is traded “ex-dividend”, i.e. the right to year t’s dividend belongs to the owner of the share at the end of year t-1.i) What is an XYZ share worth in year 3?ii) What will the price of an XYZ stock be in years 0 through 4.Q3. On Jan 28, 2008, Coca-Cola’s stock closed at $59.41, its market capitalization $137.3 billion, in real terms still below what they were then. Coca-Cola’s share price on December 31, 1996 was $52.63. The total market value of its common stock was $131 billion. Coca-Cola has been the best-performing company among the 30 companies comprising the Dow Jones over the last 10 years; an investor who put $100 into Coca-Cola stock on 12-31-1986 and reinvested dividends saw the value of his investment increase to $1,337 by 12-31-96. Dividends paid in 1996 were $1.25 billion. Could it be that Coca-Cola’s stock is somewhat overpriced?Let’s apply the Differential Growth model to this question. First, it is helpful to normalize current (= 1996) dividends equal to 100. The key, of course, is to make the right assumptions about the future growth of earnings and dividends, and on the required rate of return on Coca-Cola stock. For the latter, it does not seem unreasonable to assume that Coca-Cola stock is of average riskiness, hence setting the required rate of return to 12% p.a. seems plausible. On the growth front, things are much more iffy. Over the last 10 years, Coca-Cola’s net income grew at a (compound) average rate of 14% p.a. ; let’s assume that dividends will grow at that rate over the next 20 years, and that thereafter, they will grow only at the long-term average for the U.S. economy which of 6% (everything here is in nominal terms).i) Based on these data, dividends in year 1 (1997) are 114; how large are they in years 10, 20, 21 (=2017). Sketch a timeline representing the expected dividend stream in years 1 through 30; it should have a kink between years 20 and 21.ii) Dividends from year 1 to 20 represent a growing annuity; determine their PV.iii) Dividends after year 20 represent a delayed growing perpetuity; determine their PV.iv) Add ii) and iii) and divide by 100; this gives a “Differential Growth Factor” by which 1996 dividends are to be multiplied to determine the PV.v) Based on your answer to iv) and the above figure for 1996 dividends, compute the “fair price” (PV) of Coca-Cola stock, and compare with the total market value.vi) Under these assumptions, Coca-Cola stock is greatly overvalued. One possibility for this is that “dividends” have not been properly measured. In fact, Coca-Cola haspurchased stock from its shareholders in 1996 worth $1.400 billion; since these are also cash payments to its shareholders, they should arguably be included in the computation above. Thus, define “gross dividends” as dividends + stock repurchases = $2.657 billion. Using these “gross dividends” in part v) instead, recompute the “fair price” of Coca-Cola stock; the new figure should correspond much more closely to the Coca-Cola’s actual valuation.vii) However, the assumption of another 20 years of exceptional growth seems very optimistic. Thus, recompute the “fair price” of Coca-Cola stock based on gross dividends, but assuming that the period of exceptional growth of 14% lasts only for another 10 years, to be followed by an average growth of 6% p.a. forever. This has arather dramatic impact on the result!viii) A final bit of info: Coca-Cola is proud to have supplied almost 2 ounces of the 64 ounces of liquid intake that an average member of the world population needs each day; does this throw any light on the reasonableness of the growth assumptions made above? Q4.i) Bovine Cash leads a very placid existence: it always pays out all of its earnings as dividends; as a result, its earnings per share remain at $2.40 forever. Bovine Cash’s required rate of return is 6%. What is Bovine Cash’s fair stock price?ii) Likewise, Run-of-the-Mill’s, Inc. (RoM) predicted earnings next year are $2.40; its required rate of return is also 6%. However, RoM retains most of its earnings and keeps acquiring smaller, equally glamorous firm; the return on its investments is equal to 6%. What is Run-of-the-Mill’s fair stock price?iii) Specifically, Run-of-the-Mill always distributes 25% of its earnings, and reinvests theremaining 75% (with a return of 6% as above). What is RoM’s dividend next year?iv) How fast will RoM’s dividends grow?v) When will RoM’s dividends surpass those of Bovine