Summer 2013/14
ASSIGNMENT
This assignment is to be completed in groups of three and carries 30 per-cent of the marks in
this unit.
Part A (7 marks)
The dividend discount model assumes the value of a share of common stock is the present
value of all future dividends.
One year holding period
Assume an investor wants to buy a stock, hold it for one year, and then sell it. The company
earned $2.50 a share last year and paid a dividend of $1 a share. The company maintains a 40%
payout ratio over time. Financial analysts suggest the firm will earn about $2.75 per share
during the coming year and will raise its dividend to $1.10 per share. The risk free rate is 10%
and the market risk premium is currently 4%. You project the sale price of this stock a year
from now to be $22.
? Estimate the value of this stock.
? Would you buy this stock?
Multiple holding period
Assume the expected holding period is three years and you estimate the following dividend
payments at the end of each year.
Year 1 - $1.10 per share
The Business School
BUACC3701: Financial Management
Year 2 - $1.20 per share
Year 3 - $1/35 per share
The risk free rate is 10% and the market risk premium is currently 4%. You project the sale
price of this stock at the end of the period to be $34.
? Estimate the value of this stock.
? Would you buy this stock?
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Infinite period model with supernormal growth
The Brown Company has a current dividend of $2 per share. The following are the expected
annual growth rates for dividends. The required rate of return for the stock is 14%.
Year 1-3: 25%
Year 4-6: 20%
Year 7-9: 15%
Year 10 on: 9%
? Estimate the value of this stock.
Part B (5 marks)
In contrast to various discounted cash-flow techniques that attempt to estimate a specific value
for a stock based on its estimated growth rates and its discount rate, the relative valuation
techniques implicitly contend that it is possible to determine the value of an economic entity
(i.e., the market, an industry, or a company) by comparing it to similar entities on the basis of
several relative ratios that compare its stock price to relevant variables that effect a stock’s
value, such as earnings, cash flow, book value and sales.
Consider the following four approaches.
1. Earnings Multiplier Model
Assume a stock has an expected dividend payout of 50%, a required rate of return of 12% and
an expected growth rate for dividends of 9%. Current earnings are $2.00 per share and the
expected growth rate for earnings is 9%.
? Calculate the earnings multiplier and stock price
Briefly explain the following methods (for and against)
2. Price/Cash Flow Ratio
3. Price/Book Value Ratio
4. Price/Sales Ratio
Part C (5 marks)
Bent ltd has a bond issue that will mature to its $1000 par value in 12 years. It pays interest
annually and has a coupon rate of 11%.
a) Find the value of the bond if the required rate of return is
? 11%
? 15%
? 8%
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b) Plot your finding on a set of required return (x-axis) and market value of bond (y-axis)
c) Use your findings in parts a and b to discuss the relationship between the coupon interest
rate on a bond and the required return and the market value of the bond relative to its par
value.
d) What possible reasons could cause the required rate to differ from the coupon interest rate
Part D (13 marks)
You are required to evaluate the risk and return of the following two assets – A and B
individually and see how they might fit into a diversifiable portfolio. Equal halves would be
shared between both assets if included in a portfolio
Each asset's risk can be assessed in two ways: in isolation and as part the firm's diversified
portfolio of assets. The risk-free rate is currently 5%.
Return data for assets A and B, 2001-2010 are as follows
Asset A Asset B
Year
Cash Value Cash Value
flow Beginning Ending flow Beginning Ending
2001 1000 20000 22000 1500 20000 19000
2002 1500 22000 21000 1600 20000 19500
2003 1400 21000 24000 1700 20000 21000
2004 1700 24000 22000 1800 21000 21000
2005 1900 22000 23000 1900 21000 22000
2006 1600 23000 26000 2000 22000 23000
2007 1700 26000 25000 2100 23000 23000
2008 2000 25000 24000 2200 23000 24000
2009 2100 24000 27000 2300 24000 25000
2010 2200 27000 30000 2400 25000 25000
The market index is as follows:
Year
Market
Index
2000 200.00
2001 227.00
2002 250.00
2003 283.00
2004 312.00
2005 352.00
2006 387.00
2007 412.00
2008 447.00
2009 503.00
2010 541.00
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Required
a) Calculate the annual rate of return for each asset in each of the 10 preceding years, and
those values to find the average annual return for each asset over the 10-year period.
b) Use the returns to find the standard deviation and the coefficient of variation of the
returns for each asset over the 10-year period 2001-2010.
c) Use your findings in questions a and b to evaluate and discuss the return and risk
associated with each asset. Which asset appears to be preferable? Explain.
d) Use the CAPM to find the required return for each asset. Compare this value with average
annual returns calculated in question a.
e) Calculate the portfolio return and standard deviation of a portfolio consisting of both
stock A and Stock B
f) Calculate the weights of the minimum variance portfolio.
g) Calculate the weights of the optimal risky portfolio
h) What recommendations would you make with regard to investing in either of the two
assets or in a portfolio together?
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