FINA Exam 2 (topic 7 & 8)
The constant growth model for pricing stocks is inappropriate for
- Firms that pay no dividends - Firms with erratic earnings - Firms with supernormal growth periods
Which of the following statements correctly defines the difference between preferred stock and common stock?
- Preferred shareholders have more of a claim to dividends than common stockholders. - Preferred shareholders do not have the voting rights that common stockholders have. - Common shareholders have more exposure to variable share prices than preferred shareholders.
Russ Dress for More, a fast-growing clothier, just paid a dividend of $1.64. Analysts project annual dividend growth to be 20% for the next 4 years, and then 5% thereafter. If investors' required rate of return is 8%, what should the price of the stock be?
1. You project the dividends up to the first year of constant growth period, 2. Discount the dividends during the supernormal growth period, 3. Use the Gordon Growth Model to discount the constant growth period dividends, 4. Discount the answer to Step 3 back to present (you will discount one less year from the first constant growth dividend is paid), 5. You add all the present values you found in Steps 2 and 4, which is the value of the common stock. = $96.08
Given the information below, what is the expected return of the portfolio made up of 40% of stock A and 60% of Stock B. EconomicState Probabilityπ Stock A Stock B Recessionary .35. 12%. 2% Expansionary. .65 5% 22%
11.98
Suppose that Company ABC has a beta of .92. The expected return on the market is 13% and the market risk premium is 10.2%. According to the CAPM, the expected return for ABC is ____________.
12.18%; E[R] = (13-10.2) + .92(10.2) = 12.18%
Given the following information, this stock's expected return is ______________. Economic State Probability Return Recessionary .20 4.5% Normal .45 13.4% Expansionary .35 17.5%
13.06%; .2*4.5 + .45*13.4 + .35*17.5 = 13.06%
Suppose you bought a stock for $50 on January 1st. Six months later you received a dividend of $1.10 and you sold the stock for $53.30. Given this information, annualized return is ______________.
17.6%; (53.30-50)/50 + 1.10/50 = 0.088 six month return. We must multiply this by 2 to obtain an annualized return so 8.8%*2 = 17.6%
Suppose that Company XYZ has a beta of 1.4. The expected return on the market is 14% and the risk free rate is 3.5%. According to the CAPM, the expected return for XYZ is ____________.
18.22%; E[R] = 3.5 + 1.4(14-3.5) = 18.2%
Given the following information, this stock's standard deviation is ______________. Economic State Probability Return Recessionary .26 -12% Expansionary .74 31%
18.9% E[R] = .26*-12 + .74*31 = 19.82% Standard Deviation = [.26*(-12-19.82)2 + .74*(31-19.82)2].5 = 18.9%
Suppose that Company AXE has a beta of 1.8. The expected return on the market is 14% and the market risk premium is 11.5%. According to the CAPM, the expected return for XYZ is ____________.
23.2% (14-11.5) + 1.8(11.5) = 23.2%
Suppose that Company LMN has a beta of 1.2 and Company RST has a beta of 1.6. The expected return on the market is 14% and the risk free rate is 3%. According to the CAPM, the difference between the expected return for LMN and the expected return for RST is ____________.
4.4% E[R_LMN] = 3 + 1.2(14-3) = 16.2% E[R_RST] = 3+1.6(14-3) = 20.6% Difference = 20.6-16.2 = 4.4%
Given the following information, this stock's standard deviation is _____________. Economic State Probability Return Recessionary .20. 4.5% Normal. .45. 13.4% Expansionary. .35. 17.5%
4.65% E[R] = .20*4.5 + .45*13.4 + .35*17.5 = 13.06% Standard deviation = [.20*(4.5-13.06)2 + .45*(13.4-13.06)2 + .35*(17.5-13.06)2].5 = 4.65%
Suppose you bought a stock for $45 on January 1st. Thirty days later you received a dividend of $2.2 and you sold the stock for $44.30. Given this information, annualized return is ______________. (Assume 360 days in a year.)
40% (44.3-45)/45 + 2.2/45 = 0.0333. This is a 30 day return. We must multiply this by 360/30 or 12. 3.33%*12 = 40%
Given the following information, this stock's standard deviation is ______________. Economic State Probability Return Recessionary. .12 -3% Normal. .52 15% Expansionary .36 26%
8.9% E[R] = .12*-3 + .52*15 + .36*26 = 16.8% Standard Deviation = [.12*(-3-16.8)2 + .52*(15-16.8)2 + .36*(26-16.8)2].5 = 8.9%
The price of NetFlex stock is $54.54; its expected dividend next year is $6, and its constant annual growth rate thereafter is 5%. What is the required rate of return on the stock? Answer in percent format. Round to the nearest hundredth percent. Do not include the percent sign in your answer. (i.e. If your answer were 1.23%, then type 1.23 without a % sign)
=(6/54.54)+5% =16.00%
Cougar Auto is expecting its earnings and dividends to grow at a rate of 19% over the next 5 years. After the period, the firm is expecting to grow at the industry average of 5% indefinitely. If the firm recently paid a dividend of $1.25, and the required rate of return is 12%, what is the most you should pay for this company's stock? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)
=1.25*1.19/1.12+1.25*(1.19/1.12)^2+1.25*(1.19/1.12)^3+1.25*(1.19/1.12)^4+1.25*(1.19/1.12)^5+1.25*(1.19/1.12)^5*(1.05/(12%-5%))=32.91324615
Yesterday, firm A paid a $6 dividend to its shareholders. Dividends are expected to grow at a constant rate of 3% forever. If the required return is 12%, what is the price of the stock? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)
=Last Dividend*(1+growth rate)/(required return-growth rate) =6*(1+3%)/(12%-3%) = $68.67
A firm just issued new shares of preferred stock that will pay a dividend of $4.60. If the return required by shareholders is 10%, then the price of the preferred stock is: (Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign))
=Preferred Dividend/Return =4.6/10%=46
Jim owns shares of Abco, Inc. preferred stock which he says provides him with a constant 6.58 percent rate of return. The stock is currently priced at $45.60 a share. What is the amount of the dividend per share? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)
=Preferred stock price*Return =45.6*6.58% = $3.00048
If a security's standard deviation is high, this indicates ALL BUT THE FOLLOWING: - A greater uncertainty of the security's return. - A greater total risk of the security. - A greater likelihood of obtaining expected returns. - A higher volatility in the security's expected returns. - All of the above are indicated by a high standard deviation of a security.
A greater likelihood of obtaining expected returns
If a security's standard deviation is high, this indicates ALL BUT THE FOLLOWING: - A greater uncertainty of the security's return. - A greater total risk of the security. - A greater likelihood of obtaining expected returns. - A higher volatility in the security's expected returns. - All of the above are indicated by a high standard deviation of a security.
A greater likelihood of obtaining expected returns.
Which of the following has a beta of zero? - Both a and b - A risk-free asset - A high-risk asset - The market
A risk-free asset Beta defines the risk of an asset but risk free asset has no risk so it's beta is zero.
Hoogle has the beta of 1.95 which you calculated by running a regression. The annual T-bill rate is currently at 2.5%. Your projection of the market risk premium is 7.0%. Hoogle just paid a dividend of $1.50. What is the required rate of return for this equity?
CAPM = 2.5% + 1.95 X 7.0 = 16.2%
Firm A has preferred stock outstanding that pays a dividend of $9.50. Firm B has preferred stock outstanding that pays a dividend of $4.50. Given this information, the price of Firm A is _________________.
Cannot be determined by the information given. In order to determine the price, the return required by shareholders for that specific stock must be given.
AceBook Inc. just paid a dividend of $2.01. If its growth rate is 4% and its required rate of return is 13%, how much most would you pay for the stock? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)
Current price=D1/(Required return-Growth rate) =(2.01*1.04)/(0.13-0.04) =$23.23(Approx).
You are valuing a stock of a high growth firm. The firm just paid a dividend of $1.30 per share. The dividend is expected to grow at the rate of 21%, 18% and 13% respectively next three years. After the three year period, the dividends are going to grow at a constant rate of 5% for the foreseeable future. If the required rate of return is 8%, what is the value of this stock? Round to the nearest cent. Do not include the dollar sign in your answer. (i.e. If your answer were $1.23, then type 1.23 without a $ sign)
D1=(1.3*1.21)=1.573 D2=(1.573*1.18)=1.85614 D3=(1.85614*1.13)=2.0974382 Value after year 3=(D3*Growth rate)/(Required return-Growth rate) =(2.0974382*1.05)/(0.08-0.05)=$73.410337 Hence current value=Future dividends*Present value of discounting factor(8%,time period) =(1.573/1.08)+(1.85614/1.08^2)+(2.0974382/1.08^3)+($73.410337/1.08^3) =$62.99(Approx)
In bankruptcy, claimants are paid in the following order:
Debt holders first, preferred stockholders next, and common stockholders last.
Which one of the following is not a characteristic of common stocks?
Dividends are a fixed amount.
Which one of the following is characteristic of preferred stocks?
Dividends are cumulative.
T or F - The price of preferred stock usually varies more than the price of common stock.
False
T or F - According to the Gordon Growth Model, if the growth rate of dividends increases, the price of a stock will decrease.
False - As the growth rate increases, the price of a stock will increase
T or F - Common shareholders have preferences to dividends while preferred shareholders have preferences to ownership in the firm. TrueFalse
False - Preferred shareholders have preferences to dividends while common shareholders have preferences to ownership in the firm (i.e. voting rights)
T or F - Common stock represents a hybrid security while preferred stock represents ownership in the company.
False - Preferred stock represents a hybrid stock while both preferred stock and common stock represent ownership in the company.
T or F - The cash flows that common shareholders receive are referred to as coupons.
False - The cash flows that common shareholders receive are referred to as dividends.
Stock A has a standard deviation of 10% and a mean of 12%. Stock B has a standard deviation of 8.5% and a mean of 12%. Given this information, the distribution of returns for Stock B is wider than the distribution of returns for Stock A.
False; A larger standard deviation means that the distribution of returns around the mean is wider. Therefore, Stock A will have a wider return distribution that Stock B
1. When diversifying a portfolio, selecting stocks that have positive correlation will be more effective at mitigating risk than selecting stocks with negative correlation.
False; A portfolio made up of perfectly positive correlated stocks faces the same risk during a particular economic state.
Beta measures the level of firm-specific risk.
False; Beta measures systematic risk not firm-specific risk.
According to an upward sloping Security Market Line, stocks with higher betas will yield lower rates of return.
False; For an upward sloping security market line, higher betas will result in higher rates of return
Suppose during a particular economic period, the equity risk premium increased three percent. According to the Build-Up method, the expected return for stocks will decrease.
False; If the equity risk premium decreases, the build-up method suggests that expected returns will increase
Stocks with betas larger than zero are considered more risky than the market
False; Stocks with betas larger than one are considered more risky than the market.
The portion of risk that can be diversified away is often called systematic risk
False; Systematic risk is risk that cannot be diversified away.
Stock X has a beta of 1.4 and a standard deviation of 9%. Stock Y has a beta of 1.2 and a standard deviation of 13%. According to the Capital Asset Pricing Model, Stock Y will have a higher expected return
False; The CAPM suggests that the only firm factor that influences expected return is beta. All other risk can be diversified away. Therefore, the firm with the higher beta will have the higher expected return
In order to calculate the Annualized Return, probabilities of different economic states are needed.
False; To calculate the expected return, one needs probabilities of different economic states.
Which type of risk can be diversified away?
Firm-specific risk
Preferred stock generally has
Fixed dividends, no voting rights, and no participation.
Which of the followings is NOT another name for market risk? Idiosyncratic Beta Systematic Non-diversifiable
Idiosyncratic
When the CEO of Apple, Steve Jobs, passed away on October 4, 2011, the stock of Apple fell by close to 10% while S&P 500 went up by a little over 2%. The beta of Apple is positive. This is an example of:
Idiosyncratic Risk - Since only Apple stocks are affected by Steve Jobs' death which is an example of idiosyncratic risk.
When the CEO of Apple, Steve Jobs, passed away on October 4, 2011, the stock of Apple fell by close to 10% while S&P 500 went up by a little over 2%. The beta of Apple is positive (that is if the market goes up, then Apple stock should also go up). This is an example of:
Idiosyncratic Risk. - Idiosyncratic risk is depended on an asset or an important person of a company which cannot be diversified.
The Security Market Line (SML) is a graphical representation of returns associated with beta. Choose the correct statement regarding to the SML.
If your estimated return is below the SML, the stock is overvalued.
AceBook Inc. just paid a dividend of $2.01. Its stock is currently priced at $22.41. If its growth rate is 4% and its required rate of return is 13%, the stock is
In order to find an appropriate value of the common stock with the required rate of return of 13%, you need to use the Gordon Growth Model. %. Vcs = D1/(r - g) = D0(1+g)/(r-g) = 2.01(1+0.04)/(0.13-0.04) = 23.23. Since how much you value the stock is more than the actual price of the stock, the stock is UNDERVALUED.
You are considering investing in U.S. Steel (name of a company). Which of the following is an example of non-diversifiable risk? - Risk resulting from foreign expropriation of U.S. Steel property - Risk resulting from oil exploration by Marathan Oil (a U.S. Steel subsidy) - Risk resulting from a strike against U.S. Steel - None of the above
None of the above
If your intention was to diversify away some of the risk of your portfolio, which of the two portfolios (described below) would you want to hold? Why?
Portfolio B: 50 shares of Apple, 30 shares of Walmart, 10 Treasury Bonds, 25 shares of General Electric - Portfolio A consists of companies that are in the same industry and likely have positive correlation. If we are interested in reducing risk through the process of diversification, then portfolio B likely has assets that are less correlated than the assets in portfolio A.
Which of the following is known as a hybrid security? - Common stock - Preferred stock - Short-term debt - Long-term debt
Preferred Stock has the characteristics of equity i.e., the repayment is made when the company liquidates and dividend is paid.
A company just paid a dividend of $4 and anticipates increasing its dividend at a constant rate of 5% per year, indefinitely. Further, the return required by shareholders is 17%. According to the Gordon Model, what is the price of this firm's common stock?
Price = (4*1.05)/(.17-.05) = 35
A company is planning to pay a dividend of $3.20 and grow the dividend at a constant rate of 3% per year, indefinitely. Further, the return required by shareholders is 14%. According to the Gordon Model, what is the price of this firm's common stock?
Price = 3.20/(.14-.03) = $29.09
A firm just issued new shares of preferred stock that will pay a dividend of $4.60. If the return required by shareholders is 10%, then the price of the preferred stock is ____________.
Price = 4.6/.10 = 46
A company anticipates paying a dividend of $4 one year from today. Further, analysts predict that the price of the stock is expected to be $100 at the end of the year. According to the Holding Period Return Model, if the return required by shareholders is 12%, then the price of the stock should be ________________.
Price = 4/1.12 + 100/1.12 = $92.86
A company anticipates paying a dividend of $4 one year from today and a dividend of $6 two years from today. Further, analysts predict that the price of the stock is expected to be $100 at the end of the second year. According to the Holding Period Return Model, if the return required by shareholders is 15%, then the price of the stock should be ________________.
Price = 4/1.151^1 + 6/1.152^2 + 100/1.152^2 = 3.48 + 4.54 + 75.61 = $83.63
A company is planning to pay a dividend of $5 and keep the dividend payment of $5 per year indefinitely. The return required by share holders is 14%. According to the Gordon Model, what is the price of this stock?
Price = 5/(.14-0) = $35.71
Company RTZ has a unique dividend policy. The company anticipates paying a dividend of $4 in each of the next three years. After the third year, the company anticipates increasing the dividend at a rate of 5% per year, indefinitely. If the return required by shareholders is 14%, then the price of the stock should be ________________.
Price of stock in year 3 = (4*1.05)/(.14-.05) = 46.67 Price of stock today = 4/1.141^1 + 4/1.142^2 + 4/1.143^3 + 46.67/1.143^3 = 3.51+3.08+2.70+31.50= $40.79
Company RTZ has a unique dividend policy. The company anticipates paying a dividend of $5 one year from today, $6 two years from today, and $7 three years from today. After the third year, the company anticipates increasing the dividend at a rate of 3% per year, indefinitely. If the return required by shareholders is 15%, then the price of the stock should be ________________.
Price of stock in year 3 = (7*1.03)/(.15-.03) = 60.08. Price today = 5/1.151^1 + 6/1.152^2 + 7/1.153^3 + 60.08/1.153^3 = 4.35+4.54+4.61+39.50= $53.00
A company recently paid a dividend of $5 and anticipates decreasing the dividend at a constant rate of 2% per year, indefinitely. The current share price of the stock is $32. According to the Gordon Model, what is the return required by shareholders?
Return = (5*.98)/32 - .02 = .1331 or 13.31%
A company is planning to pay a dividend of $5 and grow the dividend at a constant rate of 3% per year, indefinitely. The current share price of the stock is $44. According to the Gordon Model, what is the return required by shareholders?
Return = (5/44) + .03 = .1436 or 14.37%
A share of preferred stock for company XYZ pays a dividend of $5.60. The price per share of preferred stock is $49.75. Given this information, the return required by preferred shareholders is _______________.
Return = 5.60/49.75 = .1126 or 11.26%
A share of preferred stock for company STO pays a dividend of $2.50. The price per share of preferred stock is $19. A share of preferred stock for company GHI pays a dividend of $3.50. The price per share of preferred stock is $28. Given this information, the return required by preferred shareholders of STO is _____________ while the return required by preferred shareholders of GHI is ________________.
Return(STO) = 2.50/19 = .1316 or 13.16% Return(GHI) = 3.50/28 = .125 or 12.50%
1. As the number of stocks in a portfolio increases, the risk of the portfolio generally decreases.
True
T or F - Both common stock and preferred stock allow shareholders a claim to the assets of the company.
True
T or F - Common shareholders have the right to vote while preferred shareholders do not.
True
T or F - If the return required by shareholders increases, then the price of a stock will decrease.
True
T or F - Suppose a company, which fell on hard times and withheld the payment of dividends to both preferred and common shareholders for the past year, decided to reinstitute the payment of dividends. The company cannot pay a dividend to common shareholders without paying dividends to preferred shareholders.
True
T or F - Suppose a company, which fell on hard times and withheld the payment of dividends to preferred shareholders for the past year, decided to reinstitute the payment of dividends. The company must pay all the dividends owed to preferred shareholders.
True - dividend payments to preferred shareholders are cumulative meaning that dividends that are withheld must be paid at some point in the future.
Suppose you bought a non-dividend paying stock for $55 one year ago. Today, you sold the stock for $60.50. Your annualized return is 10%.
True; (60.50-55)/55 * 360/360 = .10 or 10%
Suppose there is a 50% chance of having an economic recession next year and a 50% change of having economic expansion. If returns for a particular stock have historically been 8% during an economic recession and 17% during economic expansion, then the expected return is 12.5%
True; 5*8% + .5*17% = 12.5%
The security market line quantifies the risk-return tradeoff in terms of the asset's beta
True; Returns are on the y-axis and beta is on the x-axis.
Stock K has a beta of 1.5 and Stock R has a beta of 1.2. According to the Capital Asset Pricing Model, Stock K will have a higher expected return
True; The only firm factor that influences expected return is beta so Stock K will have higher expected returns than stock R
Suppose a financial instrument has returns that are the same across each economic state. Given this information, the standard deviation is 0%.
True; The squared deviation from returns in a particular economic state and the expected return is zero. Any probability multiplied by zero is zero.
The price of NetFlex stock is $54.54; its expected dividend next year is $6, and its constant annual growth rate thereafter is 5%. What is the required rate of return on the stock?
Vcs = D1/(r - g), and solve for r. 54.54 = 6/(r - 0.05). Multiply both side by (r - 0.05), so you get 54.54(r-0.05) = 6. Divide both side by 54.54, so r-0.05 = 6/54.54. Solve for r = 6/54.54 + 0.05 = 16.00%.
Andy owns a stock whose price is $29.76. If the growth rate is 6% and the required return is 13%, what is the expected dividend next year?
Vcs = D1/(r - g), so 29.76 = D1/(0.13-0.06) = D1/0.07. Multiply both side by 0.07, so you get 29.76 X 0.07 = 2.08 = D1.
Yesterday, firm A paid a $6 dividend to its shareholders. Dividends are expected to grow at a constant rate of 3% forever. If the required return is 12%, what is the price of the stock?
Vcs = D1/(r - g). The dividend of $6 is just paid, so you are given D0 So you have to grow the dividend by the growth rate of 3%. Vcs = D1/(r - g) = D0(1+g)/(r-g) = 6(1+0.03)/(0.12-0.03) = $68.67.
What's the value of preferred stock with an annual dividend of $2.06, if the required rate of return is 5.50%? (Round to nearest penny)
Vps = 2.06/0.055 = 37.45.
In which cases does the CAPM not accurately determine whether a security is under/ overvalued?
When portfolios are concentrated and investors are undiversified
You consider buying both Stock A and Stock B to make a portfolio to reduce some unsystematic risk. Both stocks will be weighted equally in the portfolio. Stock A has an expected return of 11% and a standard deviation of 18%. Stock B has an expected return of 8% and a standard deviation of 20%. If the correlation of the stocks is 1, can you reduce the unsystematic risk?
Yes: the standard deviation of the two-stock portfolio will be lower than the average standard deviation of two.
Which of the following measures systematic risk
beta
Returns on stocks A and B have equal standard deviations and are perfectly negatively correlated. In a two-stock portfolio with equal dollar investments in both stocks the portfolio standard deviation will be
equal to zero
A portfolio of Microsoft Co. and Apple Computers is better diversified than a portfolio made up of Microsoft Co. and John Deere Tractors.
false
Adding another asset to a portfolio will always reduce the riskiness of the portfolio.
false
Diversification allows investors to maximize returns by keeping much of their portfolio in a single asset.
false
True or false? A firm that has a beta equal to .75 is assumed to be riskier than the market.
false
A firm that has a beta equal to .75 is assumed to be riskier than the market. TrueFalse
false - In simple terms, a firm's beta measures how correlated the firm's returns are with the returns of the entire market's returns. Therefore, a firm is as risky as the market when the firm has a beta of 1. Firms with betas greater than 1 are considered more risky than the market while firms with betas less than 1 are considered less risky than the market. It should be noted, that correlation is bound between -1 and +1. Betas, however, are not an exact measure of correlation between a firm's returns and the market's returns. The calculation of betas, while related to the calculation of correlation, yields results that are not bound between -1 and +1.
The difference between preferred and common stock is that preferred stock
normally pays fixed dividends
A year from now, the expected price of a stock is $178; the expected dividend is $3. The required return is 10%. What is the appropriate price for the stock today?
put on calc: FV = 178+3 = 181, PMT = 0, I = 10%, N = 1. Solve for PV = 164.55.
A stock has a beta of 1.25. The risk-free rate is 3% and the market return is 9%. What is the required rate of return for the stock? Round to the nearset hundredth percent. Answer in the percent format. Do not include % sign in your answer (i.e. If your answer is 4.33%, type 4.33 without a % sign at the end.)
required return= risk-free rate +Beta*(MArket rate- risk-free rate ) =3+1.25*(9-3) = 10.5
The standard deviation for an individual stock measures
total risk
A well diversified portfolio should have a lower standard deviation of expected returns than an undiversified portfolio. TrueFalse
true
Proper diversification should reduce the riskiness associated with a portfolio
true
True or false? The beta of the S&P 500 index is equal to 1. TrueFalse
true
Using historical data, you perform regression analysis and find that Stock A has a slope of 1.4 while stock B has a slope of 1.2. Given this information, Stock A is more risky than Stock B.
true - A higher beta represents more exposure to market risk (or systematic risk).
When we assume the S&P 500 is the market, then the beta of the S&P 500 index is equal to 1.
true - In the CAPM framework, the market has a beta of 1. If the S&P 500 index is assumed to be the market, it will have a beta of 1.
