Financiad Economics ECN134 Midterm 1 Winter 2009 Prof Farshid Mojaver 20 pts 1 Some Financial Terms and Ideas a What is securitization b What is financial engineering c What is Credit Default Swap CDS d How might CDS have contributed to the current financial crisis 11 pts 2 Derivation of the formula for Growing Annuity Show that the present value of a growing annuity that pays a stream of cash flows C and grows at a constant rate g for a fixed number of periods T can be simplified to T C 1 g PV 1 r g 1 r 12 pts 3 Annuity Weak consumer spending has led automobile manufacturers to offer zero interest financing or cash back options to stimulate sales Suppose you can buy the car of your choice for its negotiated price of 16 200 less 500 cash back or you can finance the entire 16 200 car cost for 36 months at zero interest You have the cash necessary to pay for the car in an account that earns a stated annual interest rate of 4 compounded monthly You will either finance it or pay cash depending on which is the best deal a What is the cost of the financed car to you right now b Should you pay cash or finance the car and why c Now suppose the manufacturers offer 2 rather than zero percent financing Should you pay cash now or finance the car and why 6 pts 4 Annuity Pure Discount Bond Suppose that you have a pure discount bond that pays 1 000 at maturity with 6 years remaining until payoff in order to yield a 7 return a How would you price the bond b Suppose the day after you buy the bond interest rate falls to 2 What are your capital gain loss and the new yield to maturity 8 pts 5 Effective versus Stated Annual Rates In all cases give the formulas you used in obtaining the answers a Suppose the stated annual interest rate SAIR is 8 compounded quarterly what is the quarterly effective rate b Suppose the SAIR is 8 compounded quarterly what is the effective annual interest rate EAIR c Suppose the EAIR is 8 what is the 3 month effective rate d Suppose the EAIR is 8 what is the SAIR which when compounded continuously produces an 8 EAIR 12 pts 6 Stock Valuation and Growth Opportunities The stock of Nogro Corporation is currently selling for 10 per share Earnings per share in the coming year are expected to be 2 The company has a policy of paying out 50 of its earnings each year in dividends The rest is retained and invested in projects that earn a 20 rate of return per year This situation is expected to continue indefinitely a Assuming the current market price of the stock reflects its intrinsic value as computed using the constant growth DDM what rate of return do Nogro s investors require b By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested c If Nogro were to cut its dividend payout ratio to 25 what would happen to its stock price What if Nogro eliminated the dividend 15 pts 7 Stock valuation and Intrinsic Value The digital Electronic Quotation System DEQS Corporation pays no cash dividends currently and is not expected to for the next five years Its latest EPS was 10 all of which was reinvested in the company The firm s expected ROE for the next 6 years is 20 per year and during this time it is expected to continue to reinvest all of its earnings Starting 6 years from now the firm s ROE on new investment is expected to fall to 15 and the company is expected to start paying out 40 of its earnings in cash dividends which it will continue to do forever after DEQS s market capitalization rate is 15 discount rate per year What is your estimate of DEQS s intrinsic value per share a Assuming its current market price is equal to its intrinsic value what do you expect to happen to its price over the next year The year after b Since there is no dividend until period 6 why would anyone choose to own it until then What is the ROE c What effect would it have on your estimate of DEQS s intrinsic value it you expected DEQS to pay out only 20 of earnings starting in year 6 Explain 16 pts 8 Stock valuation and Deferential DDM The Duo Growth Company just paid a dividend of 1 per share The dividend is expected to grow at a rate of 25 per year for the next 3 years and then to level off to 5 per year forever You think the appropriate market capitalization rate is 20 per year a What is your estimate of the intrinsic value of a share of the stock Hint This is equal to the sum of present discounted value of the stock price in period 2 and the PV of the dividends in periods 1 and 2 b If the market price of a share is equal to this intrinsic value what is the expected dividend yield What do you expect its price to be 1 year from now Is the implied capital gain consistent with your estimate of the dividend yield and the market capitalization rate