Investment Exam #2 Problems

You are going to value Lauryn's Doll Co. using the FCF model. After consulting various sources, you find that Lauryn has a reported equity beta of 1.4, a debt-to-equity ratio of .3, and a tax rate of 30%. Based on this information, what is Lauryn's asset beta?

1.4 = BAsset x (1+ .3(1 - .30)) BAsset = 1.16

Lauryn's Doll Co. had EBIT last year of $40 million, which is net of a depreciation expense of $4 million. In addition, Lauryn made $5 million in capital expenditures and increased net working capital by $3 million. Based on this information, what is Lauryn's asset beta? then, Calculate the appropriate discount rate assuming a risk-free rate of 4% and a market risk premium of 7%. Finally, what is Lauryn's FCF for the year?

1.4 = BAsset x (1+ .3(1 - .30)) BAsset = 1.16 k = 4% + 7% (1.16) = 12.1% FCF = $40(1 - .30) + $4 - $5 - $3 = $24 million

How can frame independence lead to irrational investment decisions?

Frame dependence is the argument that an investor's choice is dependent on the way the question is posed. An investor can frame a decision problem in broad terms (like wealth) or in narrow terms (like gains and losses). Broad and narrow frames often lead the investor to make different choices. While it is human nature to use a narrow frame (like gains and losses), doing so can lead to irrational decisions. Using broad frames, like overall wealth, results in better investment decisions.

A famous economist just announced in The Wall Street Journal his findings that the recession is over and the economy is again entering an expansion. Assume market efficiency. Can you profit from investing in the stock market after you read this announcement?

Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect abnormal returns following the announcement.

Today, the following announcement was made: "Early today the Justice Department reached a decision in the Universal Product Care (UPC) case. UPC has been found guilty of discriminatory practices in hiring. For the next five years, UPC must pay $2 million each year to a fund representing victims of UPC's policies." Assuming the market is efficient, should investors not buy UPC stock after the announcement because the litigation will cause an abnormally low rate of return? Explain.

The announcement should not deter investors from buying UPC's stock. If the market is semi-strong form efficient, the stock price will have already reflected the present value of the payments that UPC must make. The expected return after the announcement should still be equal to the expected return before the announcement. UPC's current stockholders bear the burden of the loss, since the stock price falls on the announcement. After the announcement, the expected return moves back to its original level.

Several celebrated investors and stock pickers have recorded huge returns on their investments over the past two decades. Is the success of these particular investors an invalidation of an efficient stock market? Explain.

The efficient market paradigm only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excess profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention.

The dividend for Should I, Inc., is currently $1.25 per share. It is expected to grow at a 20% next year and then decline linearly to a 5% perpetual rate beginning in 4 years. If you require a 15% return on the stock, what is the most you would pay per share?

The growth rates will be 20%, 15%, and 10% in years 1-3, with a 5% rate thereafter. D1=1.25(1.20) = $1.50 D2=1.50(1.15) = $1.73 D3=1.73 (1.10) = $1.90 D4=1.90(1.05) = $1.99 P3= $1.99 / (.15 - .05) = $19.92 P0 = $1.50 / 1.15 + $1.73 / 1.152 + $1.90 / 1.153 + $19.92 / 1.153 = $16.96

What is the "illusion of knowledge" and how does it impact investment performance?

The illusion of knowledge suggests that you believe the information you hold is better than that held by other investors. Therefore, you become overconfident and believe your investment choices are better.

A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?

The market is not weak-form efficient.

Lauryn's Doll Co. had EBIT last year of $40 million, which is net of a depreciation expense of $4 million. In addition, Lauryn made $5 million in capital expenditures and increased net working capital by $3 million. Based on this information, what is Lauryn's asset beta? then, Calculate the appropriate discount rate assuming a risk-free rate of 4% and a market risk premium of 7%. Finally, what is Lauryn's FCF for the year?Using these answers, value Lauryn's Doll Co. assuming her FCF is expected to grow at a rate of 3% into perpetuity. Is this value the value of the equity?

1.4 = BAsset x (1+ .3(1 - .30)) BAsset = 1.16 k = 4% + 7% (1.16) = 12.1% FCF = $40(1 - .30) + $4 - $5 - $3 = $24 million Firm Value0 = [$24(1.03)] / (.121 - .03) = $271.67 million This is the total firm value. To get equity value, we would need to subtract the value of the firm's debt.

You are going to value Lauryn's Doll Co. using the FCF model. After consulting various sources, you find that Lauryn has a reported equity beta of 1.4, a debt-to-equity ratio of .3, and a tax rate of 30%. Based on this information, what is Lauryn's asset beta? then, Calculate the appropriate discount rate assuming a risk-free rate of 4% and a market risk premium of 7%.

1.4 = BAsset x (1+ .3(1 - .30)) BAsset = 1.16 k=4% + 7%(1.16) = 12.1%

Suppose you are flipping a fair coin in a coin-flipping contest and have flipped eight heads in a row. What is the probability of flipping a head on your next coin flip? Suppose you flipped a head on your ninth toss. What is the probability of flipping a head on your tenth toss?

As long as it is a fair coin, the probability in both cases is 50% as coins have no memory. Although many believe the probability of flipping a tail would be greater given the long run of heads, this is an example of the gambler's fallacy.

You invest $10,000 in the market at the beginning of the year, and by the end of the year you account is worth $15,000. During the year the market return was 10%. Does this mean that the market is inefficient?

Beating the market during any year is entirely possible. If you are able to consistently beat the market, it may shed doubt on market efficiency unless you are taking more risk than the market as a whole or are simply lucky. Thus, before any conclusion is made, we would want to control for the amount of risk in your portfolio.

You are given the following information concerning two stocks that make up an index. What is the price-weighted return for the index? Price/Share S.O. BEG. END Kirk 35K $37 $42 Picard 26K 84 91

Beginning index value = $37 + 84 = $121 Ending index value = $42 + 91 = $133 Return = ($133 - 121)/121 = 9.92%

Calculate the index return for the information using a value-weighted index. Price/Share S.O. BEG. END Kirk 35K $37 $42 Picard 26K 84 91

Beginning value = ($37 x 35,000) + ($84 x 26,000) = $3,479,000 Ending Value = ($42 x 35,000) + (91 x 26,000) = $3,836,000 Return = ($3,836,000 - 3,479,000) = 10.26%

What are the implications of the efficient markets hypothesis for investors who buy and sell stocks in an attempt to "beat the market"?

Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero net present value. If trading costs exist, then these investors lose by the amount of the costs.

Briefly explain mental accounting and identify the potential negative effect of this bias.

Mental accounting is when investors treat each investment separately as opposed to considering the overall wealth of their portfolios. This bias may induce investors to sell winners too early and keep losers too long.

Given the information below for Seger Corporation, compute the expected share price at the end of 2014 using price ratio analysis. YEAR 2008 2009 2010 2011 2012 2013 Price $94.50 $100.40 $99.10 $97.90 $121.50 $136.80 EPS 4.34 5.05 5.22 6.06 7.00 8.00 CFPS 7.27 8.24 8.71 10.12 11.80 13.10 SPS 52.60 58.52 57.90 60.69 71.60 78.70

P/E ratio values are: 21.77, 19.88, 18.98, 16.16, 17.36, 17.10 ; average = 18.54 EPS growth rates: 16.36%, 3.37%, 16.09%, 15.51%, 14.29% ; average = 13.12% Expected share price using P/E = 18.54($8.00)(1.1312) = $167.80 P/CFPS values are: 13.00, 12.18, 11.38, 9.67, 10.30, 10.44 ; average = 11.16 CFPS growth rates = 13.34%; 5.70%, 16.19%, 16.60%, 11.02% ; average = 12.57% Expected share price using P/CFPS= 11.16($13.10)(1.1257) = $164.61 P/S values are: 1.797, 1.716, 1.712, 1.613, 1.697, 1.738 ; average = 1.712 SPS growth rates: 11.25%, -1.06%, 4.82%, 17.98%, 9.92% ; average = 8.58% Expected share price = 1.712($78.70)(1.0858) = $146.30 A reasonable price range would seem to be $146 to $168 per share, although both the P/E and P/CFPS are at the high end of the price range.

JJ Industries will pay a regular dividend of $2.40 per share for each of the next four years. At the end of the four years, the company will also pay out a $40 per share liquidating dividend, and the company will cease operations. If the discount rate is 10%, what is the current value of the company's stock?

P0 = $2.40/(1.10)^1 + $2.40/(1.10)^2 + $2.40/(1.10)^3 + $2.40/(1.10)^4 + $40/(1.10)^4 = $34.93

JJ Industries will pay a regular dividend of $2.40 per share for each of the next four years. At the end of the four years the company will cease operations. If the discount rate is 10%, suppose the current share prices $60. What must the liquidating dividend be?

P0 = $2.40/(1.10)^1 + $2.40/(1.10)^2 + $2.40/(1.10)^3 + $2.40/(1.10)^4 + LD/(1.10)^4 = $60.00 $52.39 = LD/(1 + .10)^4 LD = $76.71

Xytex Products just paid a dividend of $1.62 per share, and the stock currently sells for $28. If the discount rate is 10%, what is the dividend growth rate?

P0 = $28 = [$1.62(1 + g)]/(.10 - g) ; g = 3.98%

Star Light & Power increases its dividend 3.8% per year, every year. This utility is valued using a discount rate of 9%, and the stock currently sells for $38 per share. If you buy a share of stock today and hold on to it for at least three years, what do you expect the value of your dividend check to be three years from today?

P0 = $38 = D1 / (.09 - .038) ; D1 = $1.98 D3 = $1.98(1.038)2 = $2.13

Bill's Bakery expects earnings per share of $2.56 next year. Current book value is $4.70 per share. The appropriate discount rate for Bill's Bakery is 11%. Calculate the share price for Bill's Bakery if earnings grow at 3% forever.

P0 = $4.70 + [$2.56 - ($4.70 × .11)] / (.11 - .03) = $30.24

Netscrape Communication does not currently pay a dividend. You expect the company to begin paying a $4 per share dividend in 15 years, and you expect dividends to grow perpetually at 5.5% per year thereafter. If the discount rate is 15%, how much is the stock currently worth?

P14 = D15 / (k - g) = $4 / (.15 - .055) = $42.11 P0 = P14 / (1.15)14 = $42.11 / (1.15)14 = $5.95

Leisure Lodge Corporation is expected to pay the following dividends over the next four years: $15.00, $10.00, $5.00, $2.20. Afterwards, the company pledges to maintain a constant 4% growth rate in dividends forever. If the required return on the stock is 10%, what is the current share price?

P4 = $2.20(1.04) / (.10 - .04) = $38.13 P0 = $15.00 / 1.10 + $10.00 / 1.102 + $5.00 / 1.103 + ($2.20 + $38.13) / 1.104 = $53.21

How do prospect theory and the concept of a rational investor differ?

Prospect theory argues that investors are willing to take more risk to avoid the loss of a dollar than they are to make a dollar profit. Also, if an investor has the choice between a sure gain and a gamble that could increase or decrease the sure gain, the investor is likely to choose the sure gain. The focus on gains and losses, combined with the tendency of investors to be risk-averse with regard to gains, but risk-taking when it comes to losses, is the essence of prospect theory. A fully rational investor (in an economic sense) is presumed to only care about his or her overall wealth, not the gains and losses associated with individual pieces of that wealth.

The efficient market hypothesis is implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore, we can simply pick mutual funds at random. Is this statement true or false? Explain.

The statement is false because every investor has a different risk preference. Although the expected return from every well-diversified portfolio is the same after adjusting for risk, investors still need to choose funds that are consistent with their particular risk level.

Critically evaluate the following statement: "Playing the stock market is like gambling. Such speculative investing has no social value, other than the pleasure people get from this form of gambling."

Unlike gambling, the stock market is a positive sum game; everybody can win. Further, with respect to speculators, they provide liquidity to markets and thus help promote efficiency.

If a market is semistrong-form efficient, is it also weak-form efficient? explain.

Yes, since historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.

Your broker commented that well-managed firms are better investments than poorly managed firms. As evidence, your broker cited a recent study examining 100 small manufacturing firms that eight years earlier had been listed in an industry magazine as the best-managed small manufacturers in the country. In the ensuing eight years, the 100 firms listed have not earned more than the normal market return. Your broker continued to say that if the firms were well managed, they should have produced better-than-average returns. If the market is efficient, do you agree with your broker?

You should not agree with your broker. The performance ratings of the small manufacturing firms were published and became public information. Prices should adjust immediately to the information, thus preventing future abnormal returns.

You did the following order book on a particular stock. The last trade on the stock was at $70.54. -Buy Orders- Shares Price 250 $70.53 100 70.52 900 70.51 75 70.49 -Sell Orders- Shares Price 100 $70.56 400 70.57 1,000 70.59 700 70.60 900 70.61 a. If you place a market buy order for 100 shares, at what price will it be filled? b. If you place a market sell order for 200 shares, at what price will it be filled? c. Suppose you place a market order to buy 400 shares. At what price will it be filled?

a. 100 shares for $70.56 b. 200 shares for $70.53 c. 100 shares for $70.56 AND 300 shares for $70.57