Finance 301: Porter

Practice Exam 3

4/9/08

S.I.

  1. If $2,000 is invested and $2,375 is returned after one year, what is the rate of return on this investment?
  2. 18.75%
  3. 15.79%
  4. 84%
  5. 16.5%
  6. Which of the following are true concerning investment risk?
  7. There are two types: standalone and portfolio
  8. It is related to the probability of earning a low or negative actual return.
  9. The greater the chance of lower than expected return, the higher the risk.
  10. A and B.
  11. All of the above
  12. A stock’s return has the following distribution:

Demand / Probability of Demand / Rate of Return 4 Demand
Weak / 0.10 / (-45%)
Below Average / 0.2 / (-12%)
Average / 0.3 / 12%
Above Average / 0.25 / 20%
Strong / 0.15 / 70%

Calculate the stocks expected return, standard deviation, and coefficient of variation.

Expected return= 12.2%

Standard Deviation= 30.99

CV= 2.54

  1. ……………………… assumes investors do not like risk and therefore require higher rates of return to hold riskier securities.
  2. Risk premium
  3. Risk aversion
  4. Correlation
  5. Stand alone risk
  1. The Capital Asset Pricing Model (CAPM) is a model that suggests that there is a Security Market Line that states that a stocks required return is equal to the risk free return + a risk premium that reflect the risk after diversification. How is this equation typicall written?
  2. ri= rRF + (rm – rRF) bi
  3. ri= the expected return on the stock
  4. rRF= risk free rate
  5. (rm-rRF)= Market Risk Premium/price of risk
  6. bi= beta of stock ‘i’ Measures how risky the stock is as part of a well diversified portfolio.
  7. How is the beta actually calculated? (THIS IS THE MOST COMMON METHOD BUT CERTAINLY NOT THE ONLY ONE)
  8. By running a regression of past returns of the stock against past returns of the market. Then the slope of the regression line is the beta coefficient.
  9. You just won the lottery, and have decided to use $5,000,000 of your money to build a well diversified portfolio of investments. The portfolio consists of the following investments and their respective betas. A FIVE STOCK PORTFOLIO IS USUALLY NOT CONSIDERED WELL DIVERSIFIED.

Stock / $ Invested / Beta
W / $1,200,000 / 1.3
X / $2,500,000 / 0.8
Y / $350,000 / 1.45
Z / $500,000 / (-0.2)
A / $450,000 / 1.75

The required rate of return on the market is 13% and the risk free rate is 5.5%. What is the portfolio’s required rate of return?

Portfolio Beta

=(1,200,o00/5,000,000)(1.3) + (2,500,000/5,000,000)(0.8) + (350,000/5,000,000)(1.45) + (500,000/5,000,000)(-0.2) + (450,000/5,000,000)(1.75)

=(.24)(1.3) + (0.5)(0.8) + (0.07)(1.45) + (0.1)(-0.2) + (0.09)(1.75)

=(0.312) + (0.4) + (0.1015) + (-0.02) + (0.1575)

bport= 0.951

rport= rRF + (rm-rRF) bport

= 5.5 + (13-5.5)0.951

= 5.5 + 7.1325

= 12.63

  1. Assume that the risk free rate is 6.5%, the expected return on the market is 12.5%. What is the required rate of return on a stock with a beta of 1.3?

ri= rRF + (rm – rRF) bi

ri= 6.5 + (12.5-6.5)1.3

ri= 6.5 + 7.8

= 14.3%

  1. Calculate the beta on a stock who’s required rate of return is 15.85%, return on the market is 13.75% and risk free rate is 5.5%.

ri= rRF + (rm – rRF) bi

15.85= 5.5 + (13.75-5.5)b

15.85= 5.5 + (8.25)b

-5.5 -5.5

10.35= 8.25b

8.25 8.25

1.2545= b

  1. The Market Risk Premium is 9%, the risk free rate is 7%. What is the expected return for the overall market? What is the required rate of return on a stock with a beta of 1.85?

MRP= rm - rRF

9= x – 7

+7 +7

16%= rm

ri= rRF + (rm – rRF) bi

= 6 + 9(1.85) (Rf is 7)

= 6 + 16.65

= 22.65%

  1. What is the % of ownership that would give you “total control” of the company. (as discussed in class)
  2. 75%
  3. 90%
  4. 99%
  5. 50%
  6. What is the % of ownership that would give you “effective control” of the company, (as discussed in class)
  7. 90%
  8. 75%
  9. 50%
  10. A percentage in the teens, 20’s or 30’s.
  11. What is the main idea of the dividend growth model?
  12. The value of stock is the NPV of all future dividends that will ever be received by the owner of the stock.
  13. What are the relevant formulas in the divided growth model?

Po=Do(1+g) or Po= D1

(rs-g) (rs-g)

Price today= Dividend today (1+growth)/(rate – growth)

D1= Do(1+g)

Dividend next year= dividend this year(1+growth rate)

  1. What are the two things that must be true in order for the dividend growth model to work?
  2. rs < g and g must be constant for at least 5 years
  3. rs > g and g must be constant forever
  4. g must grow at a steady state forever and rs < g
  5. None of the above are correct
  6. Meyer Inc. is expected to pay a $1.35 per share dividend at the end of the year. The dividend is expected to have constant growth of 8.5% per year. The required rate of return on the stock is 12%. What is the stock’s value per share?

Po= D1

(rs-g)

= 1.35

( 0.12-0.o85)

= $38.57

  1. A stock is expected to pay a dividend of $0.75 per share at the end of the year. It should grow at a rate of 7% forever. The required rate of return is 12%. What is the stock’s expected price 3 years from today?

1st, solve for the current price

Po= D1

(rs-g)

= 0.75/ (0.12-0.07)

= $15.00

Then, since the stock is growing at a constant rate, the growth rate is also the capital gains yield for the stock, and the stock rice growth rate. So, to find the price of the stock three years from today, do the following.

P4= P0( 1 + g)3

= 15 (1.07)3

= $18.38

  1. A dividend of $3.45 was just paid, and the stock is expected to grow at a constant rate of 5.5%. The required rate of return is 14%. Calculate the expected dividend stream for the next three years, and the present values of the dividends.

D1= 3.64 D2= 3.84 D3=4.05

(PV D1) 3.193 (PV D2) 2.955 (PV D3)= 2.734

  1. What is the stock’s intrinsic value?

Po= D1 = 42.82

(rs-g)

  1. What is the expected dividend yield, capital gains yield, and total return during the first year?

Dividend Yield= D1 / P0 = 8.5%

Capital Gains Yield= (P1 – P0)/ P0 =5.5%

Total Return (rs)= Dividend Yield + Capital Gains Yield = 14%

when in steady state (dividends growing at g forever) the expected capital gain is g, the dividend yield is r-g.

  1. A company is expected to have supernormal growth of 35% for the next three years. They just paid a dividend of $1.55. After the supernormal growth period, the company is expected to grow at a steady state of 7%. The firms required rate of return is 15%, what is the firms intrinsic value today?

Po= 40.00

  1. Wiebold Inc. has encountered some trouble in their business, and they are expected to have a constant growth rate of -5.5%. They just paid a dividend of $4.50 and the required rate of return is 13%. What is the value of Wiebold Inc. stock?

Po=D0(1+g)

(rs-g)

= 4.50 (1 + -0.055)

(0.13- (-0.055))

= 4.2525

0.185

= $22.99

  1. What should you know about the Corporate Value Method?
  2. It is also known as the free cash flow method.
  3. Market value of the firm is found by finding the PV of the firms FCF’s.
  4. Often preferred to the dividend growth model, esp when firms don’t pay dividends, or the dividends are hard to forecast.
  5. Assumes that at some point, FCF will grow at constant rate
  6. Terminal value represents the value of the firm when g becomes constant.
  7. How do you get from firm value to stock price?
  8. List the three firm multiples methods and the requirements of each.

**this is not meant to fully cover these three methods. I would read the material from class/check the notes this is not clear.**

  1. P/E- firms must have similar growth rates and the similar discount rate
  2. P/CF- firms must have similar growth rates, discount rates, and capital structure.(depends on cash flow measure)
  3. P/Sales- firms must have similar growth rates, discount rates, capital structure, and also similar profits
  1. What two conditions hold when in market equilibrium (stock prices are stable, and there is no pressure to buy vs. sell).
  2. The current market stock price = intrinsic value
  3. Expected returns = required returns
  4. ………………………… is a hybrid security between bonds and equity which receives a fixed dividend that must be paid before dividends are paid to common stockholders.
  5. Common Stock
  6. Special Stock
  7. Exempt Stock
  8. Preferred Stock
  9. If preferred stock with an annual dividend of $8 sells for $85, what is the preferred stock’s expected return?
  10. rp= Dp/Vp
  11. Vp= value of preferred stock
  12. Dp= the preferred dividend
  13. rp= the required rate of return on the preferred stock
  14. rp= $8/$85

= 0.094 or 9.4%