Solution to Problem Set 5 ECN 134 Financial Economics Prof Farshid Mojaver On Financial Crisis 1 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 2008 4 How are MBS CDO s and CDS related to the recent financial crisis in US 5 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 creditdefault swaps tut v financial weapons of mass destruction Questions on Stock Valuation 2 Q1 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 32 Q2 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 value of 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 CocaCola 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 has purchased 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 a rather 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 the remaining 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 Cash Hint you may use the doubling rule to give an approximate answer vi What is the PV of all future dividends Compare to ii and explain briefly Questions on Stock Valuation 3 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 …