Finance 333 Final Exam

Valuing Stocks: Example • If you sell the stock 1 year from now, you will receive a total of 35.80 per share in cash. At 7%, the present value of the cash flow would be

1 - N 7 - I/YR 0 - PMT 35.80 - FV CPT PV = -33.56

Liquidity Ratios

Ability to meet short-term, immediate obligations.

Solvency Ratios

Ability to satisfy debt obligations.

Short Sale: Initial Conditions

Dot Bomb 1000 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $100,000 Margin & Equity $50,000 Stock Owed 1000 shares

Margin Trading: Initial Conditions: Share price $100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased

Initial Position Stock $10,000 Borrowed from broker $4,000 Equity $6,000

Multiples Analysis

Simple • Prevalent • Normalizes market values by certain accounts (profits, book value) or other statistics • Two basic approaches • Comparables (Comps) • Relative valuation • Forecasted fundamentals • There is a role for intrinsic value • Justified pricing multiple • Specifies the "correct" value of the multiple • Ex. -- P/E of 18

The risk-free rate is 4%. The expected market rate of return is 11%. If you expect CAT with a beta of 1.0 to offer a rate of return of 13%, you should: Multiple Choice buy CAT because it is overpriced. sell short CAT because it is overpriced. sell short CAT because it is underpriced. buy CAT because it is underpriced. None of the options, as CAT is fairly priced.

rf + β × [E(rm) − rf] = 4% + 1.0 × (11% − 4%) = 11% < 13% = E(R) Therefore, CAT is underpriced.

Bid-asked spread

the difference between a dealer's bid and ask price

Garn-St. Germain (1982)

• MMDAs • FDIC could arrange interstate mergers

Price-to-Earnings

• Most common by far • Rule of 18 • Growth rate should be approximately equal to P/E ratio • If P/E < g then it may be a bargain to buy • PEG P0/E1 = Price(t)/earnings(t+1) Leading vs Trailing • Forecast EPS vs Last EPS

Securities Act of 1933

• Registration of securities for sale: disclosure • Prevent fraud in sale of securities

Assume you sell short 100 shares of common stock at $45 per share, with initial margin at 50%. What would be your rate of return if you repurchase the stock at $40 per share? The stock paid no dividends during the period, and you did not remove any money from the account before making the offsetting transaction. Multiple Choice 20.03% 25.67% 22.22% 77.46%

Profit on stock = ($45 − $40) × 100 = $500, $500 ÷ $2,250 (initial investment) = 22.22%

Beta Example Assume that a security is fairly priced and has an expected rate of return of 0.17. The market expected rate of return is 0.11 and the riskfree rate is 0.04. The beta of the stock is ?

17% = [4% + β(11% - 4%)] 13% = β(7%) β = 1.86

Financial Leverage and ROE

ROE = (1-t)(ROA + (ROA - r) debt/equity) • If there is no debt or ROA = r, ROE will simply equal ROA(1 - t) • If ROA > r, the firm earns more than it pays out to creditors and ROE increases • If ROA < r, ROE will decline as a function of the debt-to-equity ratio

ROA/ROE • A firm has an ROA of 14%, a debt to equity ratio of 0.8, a tax rate of 35%, and an interest rate on debt of 10%. • What is the firm's ROE?

ROE = (1-t)[ROA+(ROA-r)(D/E)] ROE = (1-0.35) [0.14+(0.14-0.10)*0.8] ROE = 11.18%

Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is: Multiple Choice underpriced. overpriced. fairly priced. Correct Cannot be determined from data provided. None of the options are correct.

5% + 1.5 × (9% − 5%) = 11% = E(r) Therefore, the security is fairly priced.

A firm has an ROE of 2%, a debt/equity ratio of 1.0, a tax rate of 0%, and an interest rate on debt of 10%. The firm's ROA is:

6% ROE = (1 − tc) × [ROA + (ROA − rDedt) Dedt ÷ Equity] 0.02 = 1 × [ROA + (ROA − 0.10) × 1] → ROA = 0.06

Your opinion is that CSCO has an expected rate of return of 0.15. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is: Multiple Choice underpriced. overpriced. fairly priced. Cannot be determined from data provided. None of the options are correct.

E(r) − rf + β × [E(rm) − rf] = 15% − [4% + 1.3 × (11.5% − 4%)] = 1.25% Therefore, the security is underpriced.

Beta

E(ri) - rf = βi (E(rm) -rf)

The risk-free rate is 7%. The expected market rate of return is 15%. If you expect a stock with a beta of 1.3 to offer a rate of return of 12%, you should: Multiple Choice buy the stock because it is overpriced. Incorrect sell short the stock because it is overpriced. Correct sell the stock short because it is underpriced. buy the stock because it is underpriced. None of the options, as the stock is fairly priced.

7% + 1.3 × (15% − 7%) = 17.4% > 12% = E(r) Therefore, the security is overpriced and should be shorted.

Activity Ratios

Effectiveness in putting its asset investment to use.

Margin Call How much can the stock price rise before a margin call?

Equity / Value of shares owned = 150,000 - 1,000P / 1,000P = .3 P = $115.38

You sold short 300 shares of common stock at $55 per share. The initial margin is 60%. At what stock price would you receive a margin call if the maintenance margin is 35%? Multiple Choice $51.00 $65.19 $35.22 $40.36 None of the options are correct.

Equity = 300($55) × 1.6 = $26,400; 0.35 = ($26,400 − 300P) ÷ 300P; 105P = $26,400 − 300P; 405P = $26,400; P = $65.18.

Free Cash Flow to Equityholders (FCFE)

FCFE = FCFF-Interest(1-t) + change in Debt Et = FCFEt+1 / ke -g

Maintenance Margin How far can the stock price fall before a margin call?

Let maintenance margin = 40% Equity = 100P - $4000 Percentage margin = (100P - $4,000)/100P (100P - $4,000)/100P = 0.40 Solve to find: P = $66.67

Constant Dividend Growth: Suppose Joe's Place, Inc. just paid a dividend of $0.50. • It is expected to increase its dividend by 10% per year. • If the market requires a return of 18% on assets of this risk, how much should the stock be selling for?

P0 = D0(1+g) /R - g = D1/R-g D1 = D0(1+g) D1= 0.50(1+0.10) = 0.55 P0 = 0.55/0.18-0.10 = $6.875

H model • You are valuing an automotive firm with a current growth rate of 27.5% which is expected to decline linearly over the next decade to a constant rate of 9.1%. Similar firms have a current required rate of return of 12.4%. What is the value of the stock today if its current dividend is $1?

P0 = D0(1+gL)+D0H(gS-gL) / (r - gL) P0 = $1(1+0.091)+$1*5(.275-0.091)/(.124-.091) P0=(1.091)+5(.184)/(.033) P0=(1.091)+.92/(.033) P0=2.011/(.033) = $60.94

PVGO Example • Suppose a stock selling for $54 just paid an annual dividend of $3/share, which was 60% of earnings. • Dividend is expected to grow at 8% indefinitely. • Market capitalization rate is 14%.

P0 = E1/k + PVGO $54 = ($3/.6) / .14 + PVGO = $35.71 + PVGO --> PVGO = $18.29

P/E Ratio Class Example • Required rate of return on ABC Company is 12% • Expected return on equity is 13% • Expected EPS for the company is $3.60 • If the firm's retention ratio is 50%, what is the firm's P/E ratio? • g = ROE * b → 13% * 50% = 6.5%

P0/E1 = 1-b/r-g = 0.50/.12 - .065 = 9.09

A preferred stock will pay a dividend of $3.00 in the upcoming year and every year thereafter; i.e., dividends are not expected to grow. You require a return of 9% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

PV0 = D1 ÷ (k − g) = $3.00 ÷ (0.09 − 0.00) = $33.33

FinCorp's free cash flow to the firm is reported as $205 million. The firm's interest expense is $22 million. Assume the corporate tax rate is 21% and the net debt of the firm increases by $3 million. What is the market value of equity if the FCFE is projected to grow at 3% indefinitely and the cost of equity is 12%?

Using FCFE, the firm's market value is $2,181.54 million: FCFE($ millions) = FCFF − Interest Expense × (1 − t) + Increases in net debt = $205 − $22 × (1 − 0.21) + $3 = $190.62 V = FCFE1 ÷ (kE − g) = ($190.62 × (1.03)) ÷ (0.12 − 0.03) = $2,181.54

Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%. A stock has an expected rate of return of 4%. What is its beta?

Using the SML: 0.04 = 0.06 + β × (0.16 − 0.06) ⇒ β = −0.02 ÷ 0.10 = −0.2

Example: Constant Growth • A stock just paid an annual dividend of $3/share. The dividend is expected to grow at 8% indefinitely, and the market capitalization rate (from CAPM) is 14%.

V0 = D0(1 + g) / r - g = D1 / r - g = $3(1+.08)/.14 - .08 = $3.24/.14-.08 = $54

Growth Rate Using DuPont Model Net profit margin 5.00% Total asset turnover 1.5 Equity multiplier 2.0 Retention ratio 60%

g = (.60)(.5)(1.5)(2.0) = 9.0% Sustainable growth rate = 9.0% • If dividends ↑ faster than 9.0%, growth will not be sustainable with internally generated funds • What is ROE for this company? • ROE = 5% *1.5 *2 • ROE = 15%

A company paid a dividend last year of $1.75. The expected ROE for next year is 14.5%. An appropriate required return on the stock is 10%. If the firm has a plowback ratio of 75%, the dividend in the coming year should be:

g = ROE × b = 0.145 × 0.75 = 0.10875 → D1 = D0 × (1 + g) = $1.75 × (1.10875) = $1.94

Financial Crisis of 2008

• 2000-2006: Sharp increase in housing prices caused many investors to believe that continually rising home prices would bail out poorly performing loans • 2004: Interest rates began rising • 2006: Home prices peaked • 2007: Housing defaults and losses on MBSs surged • 2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, and AIG • Money market breaks down • Credit markets freeze up • Federal bailout to stabilize financial system

Ask Price

• Ask prices are sell offers • In dealer markets, the ask price is the price at which the dealer is willing to sell • Investors must pay the ask price to buy the security

Rise of Systemic Risk

• Banks had mismatch between maturity and liquidity • Constant need to refinance the asset portfolio • Banks → highly levered, almost no margin of safety • Investors relied too much on credit enhancement • CDS traded mostly OTC, with no posted margin requirements and little transparency • Opaque linkages between financial instruments and institutions

Bid Price

• Bids are offers to buy • In dealer markets, the bid price is the price at which the dealer is willing to buy • Investors "sell to the bid"

Financial Asset Classes

• Bond market (Debt, Fixed Income) • Stream of income • Bonds, Money Market, Asset Backed Securities • Equity markets • Ownership • Indexes, Common Stock, Preferred Stock • Derivative markets • Payoffs determined by other asset prices • Futures, Options • Commodity markets • Currency markets

Buying on Margin

• Borrowing part of total purchase price of a position using a loan from a broker • Investor contributes remaining portion • Margin → % or amount contributed by the investor • Initial margin is set by Fed (currently 50%) • Maintenance margin • Minimum equity that must be kept in margin account • Margin call if value of securities falls too much • Profit when the stock rises

Security Market Line (SML)

• Central prediction of the CAPM • Graphs the expected return-beta relationship for each individual asset risk

Effective Use of Ratios

• Compare the company's ratios across time • Compare ratios of firms in the same industry • Cross-industry comparisons can be misleading • Examine in context of major events • Mergers, accounting changes, product mix changes

The DuPont Formulas

• DuPont formula uses relationship among financial statement accounts to decompose a return into components • Three-factor DuPont for ROE: • Total asset turnover • Financial leverage • Net profit margin • Five-factor DuPont for ROE: • Total asset turnover • Financial leverage • Operating profit margin • Effect of nonoperating items • Tax effect

Economic Value Added

• EVA is the difference between return on capital (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm • EVA is also called residual income • If ROA > k, value is added to the firm

DIDMCA (1980)

• Eliminated Regulation Q • Banks could pay interest on checking accounts

• Riegel-Neal (1994)

• Eliminated prohibitions on interstate banking • BHCs could buy banks coast-to-coast • Bank of America/Nationsbank was first in 1998

Economic Value Added Example In 2012, Intel's cost of capital was 7.8%. Its ROC was 13.9% and its capital base was $56.34 billion

• Intel's EVA = (0.139-0.078) x $56.34 billion = $3.44 billion

Asset Classes

• Money Market • New issue • Key factor: issuer receives proceeds from the sale • Short-term, liquid, low-risk • Ex. T-bills, CDs, CP • Capital Markets • Existing owner sells to another party • Issuing firm does not receive proceeds and is not directly involved • Longer-term, riskier • Ex. Treasury notes, Bonds, Stock, Derivatives

Dodd-Frank (2010)

• Mostly affected regulatory agencies as opposed to Wall Street in particular • Consolidation of regulatory agencies • More regulation of financial institutions, particularly with respect to derivatives • More regulation of hedge funds as well • Consumer protection reforms (no more predatory lending) • New rules and tools for dealing with financial crises • Revision of "too big to fail" • Orderly liquidations • More coordination internationally

Sarbanes-Oxley (2003)

• Only applies to public firms, and drastically increased the cost of being public • Saw a dramatic amount of delisting following the passage of SOX • Required more disclosure of both on- and offbalance sheet items • Better auditor and internal governance controls • Independence of compensation committees • Restore confidence in public firms

Present Value of Growth Opportunities

• Present value of growth opportunities (PVGO) is the net present value of a firm's future investments. • The value of the firm is the sum of the following: • Value of assets already in place (no-growth value). • Net present value of the future investments the firm will make, or PVGO. P0 = E1/k + PVGO

Decomposition of ROE

• ROA=EBIT/Sales x Sales/Assets = margin x turnover • Margin and turnover are unaffected by leverage • ROA reflects soundness of firm's operations, regardless of how they are financed • ROE=Tax burden x ROA x Compound leverage factor • Tax burden is not affected by leverage • Compound leverage factor= Interest burden x Leverage

Securities Exchange Act of 1934

• Regulation of exchanges (and eventually Nasdaq) • Created Securities and Exchange Commission • Required periodic disclosures (10Ks, 10Qs, 8Ks, etc.) • Expanded anti-fraud laws (first insider trading prohibitions)

Gramm-Leach-Bliley (1999)

• Repealed Glass-Steagall • Commercial banks could now engage in investment banking activities • Travelers/Citibank was first in 1998 • Spurred by CSFB, Deutsche Bank Alex Brown • Difficult for US firms to compete against foreign universal banks

Glass-Steagall (1933)

• Separated commercial banks from investment banks

Capital Asset Pricing Model

• Set of predictions concerning expected returns for risky assets in equilibrium • Based on two sets of assumptions: • Individual behavior • Market structure • Provides us with a measure of an asset's expected return based on its risk • Gives benchmark rate of return to compare different investments

Non-Constant Growth Stock Example What is the value of a share of stock that just paid a dividend of $2, if this dividend will grow at a rate of 10% for the next 3 years, and then 5% forever beginning in Year 4, assuming that investors require a 20% return? Step 1 - calculate D1, D2, D3, and D4 Step 2 - value the growing perpetuity Step 3 - discount everything back to time 0

• Step 1 - Calculate the Extraordinary Dividends and the first constant growth dividend. I% 0 1 2 3 ∞ D1 D2 D4 D∞ 4 D3 Non-Constant Growth Constant Growth • D1 = $2(1.10) = $2.20 • D2 = $2(1.10)^2 = $2.42 • D3 = $2(1.10)^3 = $2.66 • D4 = $2(1.10)^3 (1.05) = $2.80 Step 2 - Calculate the price of the growing perpetuity. P3 = D4/R-g = $2.80 / 0.20 -0.05 = $18.67 • Step 3 - Discount each piece back to today and add them together. This is the price. P0 = = $2.20/1.20 + $2.42/(1.20)^2 + $2.66 /(1.20)^3 + $18.67/(1.20)^3 = $15.86

Algorithmic Trading

• Use computer programs to make trading decisions

Types of Market Efficiency

• Weak form • Random walk • Don't confuse randomness and irrationality • Trading rules & technical analysis • Semi-strong form • Public Information • Event studies • Fundamental Analysis • Strong form • Private information • Insider trading • Evidence: Can we predict future stock prices with information that we have? • Risk premium vs Inefficiency • Data mining & data dredging

Honda Example • Honda's ROE = 10% • Retention ratio (b)= 75% • Expected dividends for Honda: Year 1 $.78 Year 3 $ .92 Year 2 $.85 Year 4 $1.00 • Steady state growth rate (g) = ROE*(b) • Honda's beta = 0.95 and risk-free rate is 2%. • If the market risk premium is 8%, then r is: • r=rf+β(rm-rf) • r=2% + 0.95(8%) = 9.6% • How much is 1 share of Honda worth today? • First - find the Terminal Value of Honda • Second - discount all cash flows back

• What is Honda's SGR? •g = 10% (75%) = 7.5% • Finding the terminal value using Constant Growth P2016 = D2017/r-g = D2016(1+g) /r-g = $1(1.075)/0.096 - 0.075 = $51.19 • Discounting all CFs back to 2012 V2012 = 0.78/1.096 + 0.85/1.096^2 + 0.92/1.096^3 + 1+51.19/1.096^4 • Today, one share of Honda Motor Company Stock is worth $38.28.

Valuing Stocks: 2 period Example • Now, what if you decide to hold the stocks for 2 years? • In addition to the $0.80 dividend in year 1, you expect a dividend of $1.20 and a stock price of $41 both at the end of year 2. • Now how much would you be willing to pay for one stock of CPSI? • You will receive $0.80 per share at the end of year 1 and a total of $42.20 per share at the end of year 2. • At 7%, the present value of the cash flow would be:

• 𝑃𝑉 = 0.80 / 1+0.07 + 41+1.20 / (1+0.07)^2 = 𝟑𝟕. 𝟔𝟏 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 Calculator: • CF0 = 0 • C01 = 0.8; F01 = 1 • C02 = 42.20; F02 = 1 • NPV → I = 7 • CPT → 37.61

Fundamental Analysis

•Analysis of balance sheets, earnings reports, dividend announcements, interest rates, etc. to arrive at proper stock prices • Try to find firms better than everyone else's estimate • Try to find poorly run firms not as bad as market thinks • Semi strong form efficiency and fundamental analysis

The Financial Crisis of 2008

•Antecedents of the Crisis: • Fed response to high-tech bubble of 2000 to 2002 was an aggressive reduction in interest rates. • T-bill rates dropped drastically between 2001 and 2004. • The recession was mild and brief→ the "Great Moderation." • Historic boom in housing market resulted from seemingly stable economy and dramatically reduced interest rates. • Greater tolerance for risk, such as securitized mortgages

Short Sales

•Purpose → profit from decline in price of a stock or security • Mechanics • Borrow stock through a dealer • Sell it and deposit proceeds and margin in an account • Closing out the position: Buy the stock and return to the party from which it was borrowed

Google Example • Google has a beta of 1.0. • Annualized market return yesterday was 11% • Risk free rate is 5% • Yesterday, Google had an annualized return of 14% • If markets are efficient, what does this suggest?

𝐸 𝑟 = 𝑟𝑓 + 𝛽(𝐸(𝑟𝑚) − 𝑟𝑓) 𝐸 𝑟 = .05 + 1.0(.11 − .05) 𝐸 𝑟 = .11 Expect 11% return, actual return is 14% → 3% abnormal return

Valuing Stocks: 3 period Example • Finally, what if you decide to hold the stocks for 3 years? • In addition to the year1 dividend of $0.80, year2 dividend of $1.20, you also expect to receive a dividend of $1.80 and a stock price of $44.5 both at the end of year3. • Now how much would you be willing to pay for one stock of CPSI? • At 7%, the present value of the cash flow would be:

𝑃𝑉 = 0.80/1+0.07 + 1.20 / (1+0.07)^2 +$44.5+$1.80 / (1+0.07)^3 = 𝟑𝟗. 𝟓𝟗/ 𝒔𝒉𝒂𝒓𝒆 Calculator • CF0 = 0 • C01 = 0.8; F01 = 1 • C02 = 1.2; F02 = 1 • C03 = 46.3; F03 = 1 • NPV → I = 7 • CPT NPV = 39.5904

Decomposition of ROE: DuPont Method

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 /𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 / 𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 × 𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 / 𝐸𝐵𝐼𝑇 × 𝐸𝐵𝐼𝑇 / 𝑆𝑎𝑙𝑒𝑠 × 𝑆𝑎𝑙𝑒𝑠 / 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐸𝑞𝑢𝑖𝑡𝑦 1.Tax Burden 2.Interest Burden 3.Margin 4.Turnover 5.Leverage

Horizontal common-size analysis

Uses account amounts in a specified year as the base • Subsequent years' stated as a % of base value • Useful to compare growth of different accounts over time

Vertical common-size analysis

Uses aggregate value for a given year as the base • Each account is restated as a % of the aggregate • Balance sheet: Aggregate amount is total assets • Income statement: Aggregate amount is revenues or sales

Free Cash Flow for the Firm (FCFF)

1. Discount the FCFF at the weighted-average cost of capital to find the value of entire firm • Free cash flow to the firm, FCFF, is the after-tax cash flow generated by the firm's operations, net of investments in fixed as well as working capital 2. Subtracting the value of debt results in the value of equity Free Cash Flow for the Firm (FCFF) FCFF = EBIT (1 -t) + Depreciation - Cap. Exp. - change in NWC Vt = FCFFt+1 / WACC - g

Industry Structure and Performance: Five Determinants of Competition

1. Threat of entry 2. Rivalry between existing competitors 3. Pressure from substitute products 4. Bargaining power of buyers 5. Bargaining power of suppliers

A firm has a P/E ratio of 12, an ROE of 13%, and a market-to-book value of:

1.56 E ÷ P = ROE ÷ (P ÷ B) 1 ÷ 12 = 0.13 ÷ (P ÷ B) P ÷ B = 1.56

Alpha Example Security A has an expected rate of return of 0.10 and a beta of 1.3. The market expected rate of return is 0.10 and the riskfree rate is 0.04. The alpha of the stock is: • Is this stock under or over priced?

10% - 4% = α+1.3(10% - 4%) = -1.8% • Over (negative alpha)

You purchased 100 shares of IBM common stock on margin at $130 per share. Assume the initial margin is 50%, and the maintenance margin is 30%. Below what stock price level would you get a margin call? Assume the stock pays no dividend; ignore interest on margin. Multiple Choice $21.24 $92.86 $49.52 $80.33 $130.00

100 shares × $130 × 0.5 = $13,000 × 0.5 = $6,500 (loan amount); 0.30 = (100P − $6,500) ÷ 100P; 30 − P = 100P − $6,500; −70P = −$6,500; P = $92.86

You purchased 100 shares of common stock on margin at $45 per share. Assume the initial margin is 50%, and the stock pays no dividend. What would the maintenance margin be if a margin call is made at a stock price of $30? Ignore interest on margin. Multiple Choice 0.33 0.55 0.43 0.23 0.25

100 shares × $45per share × 0.5 = $4,500 × 0.5 = $2,250 (loan amount); X = [100($30) − $2,250] ÷ 100($30); X = 0.25.

Assume you purchased 200 shares of KO common stock on margin at $70 per share from your broker. If the initial margin is 55%, how much did you borrow from the broker? Multiple Choice $6,000 $4,000 $7,700 $7,000 $6,300

200 shares × $70 per share × (1 − 0.55) = $14,000 × (0.45) = $6,300.

You purchased 300 shares of common stock on margin for $60 per share. The initial margin is 60%, and the stock pays no dividend. What would your rate of return be if you sell the stock at $45 per share? Ignore interest on margin. Multiple Choice 25.00% -33.33% 44.31% -41.67% -54.22%

300 × $60 × 0.60 = $10,800 investment; 300 × $60 × 0.40 = $18,000 × 0.40 = $7,200 loan; Proceeds after selling stock and repaying loan: $13,500 - $7,200 = $6,300; Return = ($6,300 − $10,800) ÷ $10,800 = −41.67%

Initech is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4%, and the expected return on the market portfolio is 14%. Analysts expect the price of Initech shares to be $22 a year from now. The beta of Initech's stock is 1.25. The market's required rate of return on INitech's stock is:

4% + 1.25(14% − 4%) = 16.5%

P/E Ratio • ABC Company is trading at $30, EPS of $2.00/sh • P/E of 15x • XYZ Company is trading at $20, EPS of $0.67/sh • P/E of 30x • Industry P/E is 15x • Which stock is a better buy?

ABC Co.→ better buy, pay less for every $1 of earnings • XYZ Co. → has a higher P/E than ABC and industry • Investors expect higher earnings in future relative to market

Profitability Ratios

Ability to manage expenses to produce profits from sales.

Short Sale: Dot Bomb falls to $70 per share

Assets $100,000 (sale proceeds) $50,000 (initial margin) Liabilities $70,000 (buy shares) Equity $80,000 Profit = Ending equity - Beginning equity = $80,000 - $50,000 = $30,000 = Decline in share price x Number of shares sold short

Real Assets vs. Financial Assets

Assets used to produce goods and services (e.g., land, buildings, machines, IP) vs Claims to income generated by real assets (e.g., stocks and bonds)

A security has an expected rate of return of 0.12 and a beta of 1.1. The market expected rate of return is 0.09, and the risk-free rate is 0.04. The alpha of the stock is: Multiple Choice 9.7%. 7.7%. 5.3%. 2.5%. None of the options are correct.

E(r) − rf + β × [E(rM) − rf] = 12% − [4% + 1.1 × (9% − 4%)] = 2.50%

Change in Margin % Stock price falls to $70 per share

New Position Stock $7,000 Borrowed from broker $4,000 Equity $3,000 Margin = Equity in Account / Value of Stock

If the simple CAPM is valid, is the situation shown below possible? Portfolio Expected Return Beta Risk-free 10% 0 Market 18% 1.0 A 16% 1.5

Not possible. The SML for this scenario is: E(r) = 10 + β × (18 − 10) Portfolios with beta equal to 1.5 have an expected return equal to: E(r) = 10 + [1.5 × (18 − 10)] = 22% The expected return for Portfolio A is 16%; that is, Portfolio A plots below the SML (αA = −6%) and, hence, is an overpriced portfolio. This is inconsistent with the CAPM.

Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%. A share of stock sells for $50 today. It will pay a dividend of $6 per share at the end of the year. Its beta is 1.2. What do investors expect the stock to sell for at the end of the year?

Since the stock's beta is equal to 1.2, its expected rate of return is: 0.06 + [1.2 × (0.16 − 0.06)] = 18% E(r) = (D1 + P1 − P0) ÷ P0 → 0.18 = (P1 − $50 + $6) ÷ $50 → P1 = $53

Technical Analysis & Trading

Trend extrapolation • Filter rules • Resistance points • Mean reversion • Serial correlation • Moving averages • Indicators • Confidence index • Put/Call ratio

Financial Ratio Analysis

Use relationships among financial statement accounts to assess the financial condition/performance of a company

JCPenney Company is expected to pay a dividend in year 1 of $1.65, a dividend in year 2 of $1.97, and a dividend in year 3 of $2.54. After year 3, dividends are expected to grow at the rate of 8% per year. An appropriate required return for the stock is 11%. The stock should be worth _________blank today.

Year Dividend PV of Dividend@11% 1 $ 1.65 $1.65 ÷ 1.11 = $ 1.4865 2 $ 1.97 $1.97 ÷ (1.11)^2 = $ 1.5989 3 $ 2.54 $2.54 ÷ (1.11)^3 = $1.8572 Sum $ 4.94 P0 = (D1 ÷ (1 + k)^1) + ... + (DH ÷ (1 + k)^H) + (PH ÷ (1 + k)^H) where PH = (DH+1 ÷ (k − g)) = ($1.65 ÷ (1.11)^1) + ($1.97 ÷ (1.11)^2) + ($2.54 ÷ (1.11)^3) + ((($2.54 × (1.08)) ÷ (0.11 − 0.08)) ÷ (1.11)^3) = $71.80

You are bullish on Telecom stock. The current market price is $240 per share, and you have $24,000 of your own to invest. You borrow an additional $24,000 from your broker at an interest rate of 9% per year and invest $48,000 in the stock. Required: a. What will be your rate of return if the price of Telecom stock goes up by 14% during the next year? The stock currently pays no dividends. b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.

a. At $240 per share, you buy 200 shares of Telecom for $48,000 with $24,000 margin. Shares increase in value by 14%, or $6,960. The rate of return will be: ($261.60 × 200 − $24,000 − ($24,000 + 0.09 × $24,000)) ÷ $24,000 = -0.38 b. The value of the 200 shares is 200P. Equity is (200P − $24,000). You will receive a margin call when: ((200 × P − $24,000) ÷ 200 × P) = 0.30 ⇒ when P = $171.43 or lower

Use the information in the table below to answer the following questions. Windswept Woodworks, Incorporated Input Data (millions of dollars) Year 2 Year 1 Accounts payable 460 404 Accounts receivable 1,304 850 Accumulated depreciation 6,770 6,652 Cash & equivalents 248 148 Common stock 1,208 1,140 Cost of goods sold 1,500 n.a. Depreciation expense ? n.a. Common stock dividends paid ? n.a. Interest expense 140 n.a. Inventory 1,038 1,046 Addition to retained earnings 602 n.a. Long-term debt 836 756 Notes payable 230 380 Gross plant & equipment 10,260 10,000 Retained earnings 3,086 2,496 Sales 3,018 n.a. Other current liabilities 116 96 Tax rate 34% n.a. Market price per share - year end $ 19.80 $ 17.50 Number of shares outstanding 500 million 500 million Net profit = $831.60 Required: a.

a. ROE = Net profit ÷ Equity = 831.60 ÷ (1,208 + 3,086) = 19.37% b. Profit margin = EBIT ÷ Sales = 1,400 ÷ 3,018 = 0.46 c. Tax burden ratio = Net profit ÷ Pretax profit = 831.60 ÷ 1,260 = 0.66 d. Interest burden ratio = Pretax profit ÷ EBIT = 1,260 ÷ 1,400 = 0.90 e. Asset turnover ratio = Sales ÷ Assets = 3,018 ÷ 6,080 = 0.50 f. Leverage ratio = Assets ÷ Equity = 6,080 ÷ 4,294 = 1.42 The product of these is 0.66 × 0.90 × 0.46 × 0.50 × 1.42 = 0.1937 = 19.37%, the same as the directly calculated ROE

Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model: Required: a. What is the expected rate of return on the market portfolio? Note: Round your answer to 1 decimal place. b. What would be the expected rate of return on a stock with β = 0? Note: Round your answer to 1 decimal place. c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next year and you expect it to sell then for $41. The stock risk has been evaluated at β = −0.5. Is the stock overpriced or underpriced?

a. Since the market portfolio has a beta of 1, its expected rate of return is 12%. b. β = 0 means no systematic risk. Hence, the stock's expected rate of return in market equilibrium is the risk-free rate, 5%. c. Using the SML, the fair expected rate of return for a stock with β = -0.5 is: E(r) = 0.05 + [(−0.5) × (0.12 − 0.05)] = 1.5% The actually expected rate of return, using the expected price and dividend for next year is: E(r) = ($41 + $3) ÷ $40 − 1 = 0.10 = 10% > 1.5% Because the expected return exceeds the fair return, the stock is underpriced.

Old Economy Traders opened an account to short-sell 1,800 shares of Internet Dreams at $56 per share. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $56 to $60, and the stock has paid a dividend of $3.00 per share. Required: a. What is the remaining margin in the account? b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call? c. What is the rate of return on the short position (treating the initial margin as the amount invested)?

a. The initial margin was: 0.50 × 1,800 × $56 = $50,400 As a result of the increase in the stock price Old Economy Traders loses: $4 × 1,800 = $7,200 Margin decreases by $7,200. Old Economy Traders must pay the dividend of $3.00 per share to the lender of the shares; the margin in the account decreases by an additional $5,400. Therefore, the remaining margin is: $50,400 − $7,200 − $5,400 = $37,800 b. The percentage margin is: $37,800 ÷ $108,000 = 0.35, or 35% > 30% There will be no margin call. c. The equity in the account decreased from $50,400 to $37,800 in one year, for a rate of return of: (−$12,600 ÷ $50,400) = −0.2500 or −25.00. ($100,800 − $108,000 − $3.00 × 1,800) ÷ $50,400 = −0.2500, or −25.00%

The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its earnings in dividends, and the latest earnings announced were $10 per share. Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per year on all reinvested earnings forever. Required: a. What is the intrinsic value of a share of Xyrong stock? Note: Do not round intermediate calculations. Round your answer to 2 decimal places. b. If the market price of a share is currently $100, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected 1-year holding-period return on Xyrong stock?

a. The intrinsic value of $101.82 k = rf + βXyrong × (rm − rf) = 0.08 + 1.2 × (0.15 − 0.08) = 0.164 g = ROE × b = 0.20 × (1 − 0.40) = 0.20 × 0.60 = 0.12 V0 = D1 ÷ (k − g) = (EPS0 × (1 + g) × (1 − b)) ÷ (k − g) = ($10.00 × (1.12) × 0.40) ÷ (0.164 − 0.12) = $101.82 b. If your model is correct, the price of Xyrong Corporation is: k = (Div1 + E(P1) − V0) ÷ V0 0.164 = ($4.48 + E(P1) − $101.82) ÷ $101.82 → E(P1) = $114.04 However, Xyrong Corporation is trading at $100.00 currently, implying an expected holding period return of 18.52%: HPR = (Div1 + E(P1) − P0) ÷ P0 = ($4.48 + $114.04 − $100.00) ÷ $100.00 = 0.1852

The FI Corporation's dividends per share are expected to grow indefinitely by 5% per year. Required: a. If this year's year-end dividend is $8 and the market capitalization rate is 10% per year, what must the current stock price be according to the DDM? b. If the expected earnings per share are $12, what is the implied value of the ROE on future investment opportunities? Note: Do not round intermediate calculations. c. How much is the market paying per share for growth opportunities (i.e., for an ROE on future investments that exceeds the market capitalization rate)?

a. V0 = D1 ÷ (k − g) = $8.00 ÷ (0.10 − 0.05) = $160.00 b. ROE is 6.67% D1 = EPS1 × (1 − b) $8.00 = $12.00 × (1 − b) → b = 0.33 g = ROE × b 0.05 = ROE × 0.33 → ROE = 15.00% c. The PVGO is $40.00 Price = (E1 ÷ k) + PVGO $160.00 = ($12.00 ÷ 0.10) + PVGO → PVGO = $40.00

Use the information in the table below to calculate the following ratios for Windswept Woodworks for year 1 and year 2. a. Interest coverage ratio (Assume that year 1 EBIT was $1,297 and year 1 interest expense was $120 b. Average collection period (Assume that the accounts receivable balance was $950 on December 31 of the previous year and that year 1 sales were 2,700.) c. Current ratio d. Quick ratio

a. Year 2 interest coverage ratio = 1,404 ÷ 140 = 10.03 Year 1 interest coverage ratio = 1,297 ÷ 120 = 10.81 b. Year 2 ACP = [((1,280 + 830) ÷ 2) ÷ 3,018] × 365 = 127.59 days Year 1 ACP = [((830 + 950) ÷ 2) ÷ 2,700] × 365 = 120.31 days c. Year 2 current ratio = 2,518 ÷ 782 = 3.22 Year 1 current ratio = 1,984 ÷ 860 = 2.31 d. Year 2 quick ratio = (2,518 - 1,014) ÷ 782 = 1.92 Year 1 quick ratio = (1,984 - 1,026) ÷ 860 = 1.11

The cost of buying and selling a stock consists of: Multiple Choice broker's commissions only. dealer's bid-asked spread only. a price concession an investor may be forced to make only. broker's commissions and dealer's bid-asked spread. broker's commissions, dealer's bid-asked spread, and a price concession an investor may be forced to make.

broker's commissions, dealer's bid-asked spread, and a price concession an investor may be forced to make.

Systemic Risk

problems in one market spill over and disrupt others • One default may set off a chain of further defaults • Contagion effect