Your Name Midterm 2 Financial Economics Spring 2010 Descriptive and Conceptual Questions 4 pts 1 Describe one weakness inherent in all DDMs Answer All DDMs are very sensitive to input values Small changes in k or g can imply large changes in estimated intrinsic value These inputs are difficult to measure 9 pts 2 Identify within the context of the constant dividend growth model how each of the following factors would affect the P E ratio of stock ABC a Risk beta of ABC b Estimates growth rate of earnings and dividends c Market risk premium Answer a The P E ratio is a decreasing function of riskiness as risk increases the P E ratio decreases b The P E ratio is an increasing function of the growth rate of the firm the higher the expected growth the higher the P E ratio c The P E ratio is a decreasing function of the market risk premium An increased market risk premium increases the required rate of return lowering the price of a stock relative to its earnings 6 pts 3 Explain how an increase in dividend payout would affect each of the following holding all other factors constant a Sustainable growth rate b Growth in book value Answer a An increase in dividend payout will reduce the sustainable growth rate as less funds are reinvested in the firm The sustainable growth rate i e ROE x plowback will fall as plowback ratio falls b The increased dividend payout rate will reduce the growth rate of book value for the same reason less funds are reinvested in the firm 4 pts 4 Provide a formal definition of beta in a SML and explain what it measures Answer Formal definition i Cov r i r M 2 r M Beta describes the relative variability of returns It measures the risk contribution of a security to the market portfolio relative to the variance of the market portfolio It is a measure of the systematic risk of a security in the market portfolio 4 pts 5 How is beta measured empirically Answer Empirically Beta is estimated using the Characteristic Line r it ai birMt eit The beta of the market portfolio market is equal one 7 pts 6 Describe the two steps in which an individual investor comes up with an optimal portfolio of risky and risk free assets Use a graph to make your points Answer Short Answer questions 4 pts each 1 If the expected rate of return of the market portfolio is 15 and a stock with a beta of 1 0 pays a dividend yield of 4 what must the market believe is the expected rate of price appreciation on that stock Answer Since beta 1 0 then k market return 15 Therefore 15 D1 P0 g 4 g g 11 2 The common stock of Flavorful Teas has an expected return of 14 4 The return on the market is 10 and the risk free rate of return is 3 5 What is the beta of this stock Answer E r 144 035 10 035 109 065 1 68 3 The stock of Big Joe s has a beta of 1 14 and an expected return of 11 6 The risk free rate of return is 4 What is the expected return on the market Answer E r 116 04 1 14 rm 04 1216 1 14rm rm 1067 10 67 4 What percentages of your money must be invested in the risky asset and the risk free asset respectively to form a portfolio with an expected return of 0 09 Answer 9 w1 12 1 w1 5 9 12 w1 5 5 w1 4 7 w1 w1 0 57 1 w1 0 43 verify 0 57 12 0 43 5 8 99 5 SGA Consulting had a FCFE of 3 2M last year and has 3 2M shares outstanding SGA s required return on equity is 13 FCFE is expected to grow at 8 5 forever What is the intrinsic value of SGA s shares 3 2M 3 2M 1 00 FCFE per share 1 00 1 085 1 085 1 085 13 085 24 11 6 Fly Boy Corporation is expected have EBIT of 800k this year Fly Boy Corporation is in the 30 tax bracket will report 52 000 in depreciation will make 86 000 in capital expenditures and have a 16 000 increase in net working capital this year What is Fly Boy s FCFF FCFF EBIT 1 T depreciation capital expenditures increase in NWC FCFF 800 000 7 52 000 86 000 16 000 510 000 Problem solving questions 18 pts 1 Stock valuation 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 present value of growth opportunities c 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 V 0 is greater or less than P0 a V 0 no longer equals P0 and why k rf rM rf 6 1 25 14 6 16 g 2 3 9 6 D1 E0 1 g 1 b 3 1 06 1 3 1 06 b D1 1 06 10 60 k g 0 16 0 06 E 3 18 PVGO P0 1 10 60 9 275 k 0 16 P0 The low P E ratios and negative PVGO are due to a poor ROE 9 that is less than the market capitalization rate 16 c Now you revise b to 1 3 g to 1 3 9 3 and D1 to E0 1 03 2 3 2 06 Thus V0 2 06 0 16 0 03 15 85 V0 increases because the firm pays out more earnings instead of reinvesting a poor ROE This information is not yet known to the rest of the market 6 pts 2 Risk Aversion Consider a portfolio that offers an expected rate of return of 12 and a standard deviation of 18 T bills offer a risk free 7 rate of return What is the maximum level of risk aversion for which the risky portfolio is still preferred to bills Answer When we specify utility by U E r 0 5A 2 the utility level for T bills is 0 07 The utility level for the risky portfolio is U 0 12 0 5A 0 18 2 0 12 0 0162A In order for the risky portfolio to be preferred to bills the following inequality must hold 0 12 0 0162A 0 07 A 0 05 0 0162 3 09 6 pts 3 Return and Risk Consider a portfolio that is invested 40 in stock Q and 60 in stock R a …