Foundations of Finance
Summer Semester 2012
Due Saturday 06/16 (in class)
Part I: Multiple Choice
1) All else the same, a higher plowback ratio means a(n) … P/E ratio
D) unable to determine
2) An underpriced stock provides an expected return, which is … the required return based
on the capital asset pricing model (CAPM).
A) less than
B) equal to
C) greater than
D) greater than or equal to
3) You wish to earn a return of 10% on each of two stocks, A and B. Each of the stocks is
expected to pay a dividend of $4 in the upcoming year. The expected growth rate of
dividends is 6% for stock A and 5% for stock B. Using the constant growth DDM, the
intrinsic value of stock A …
A) will be higher than the intrinsic value of stock B
B) will be the same as the intrinsic value of stock B
C) will be less than the intrinsic value of stock B
D) more information is necessary to answer this question
4) You are considering acquiring a common share of R&A Shopping Center Corporation
that you would like to hold for one year. You expect to receive both $1.25 in dividends
and $35 from the sale of the share at the end of the year. The maximum price you would
pay for a share today is … if you wanted to earn a 12% return.
5) The discount rate on the stock of K&O Wholesale Company is 10%. Its expected ROE is
12% and its expected EPS is $5.00. If the firm's plowback ratio is 40%, its P/E ratio will
6) C&N Trading Company is expected to have EPS in the upcoming year of $6.00. The
expected ROE is 18.0%. An appropriate required return on the stock is 14%. If the firm
has a plowback ratio of 60%, its growth rate of dividends should be …
7) Stern Enterprises is expected to have EPS (Earnings per share) in the upcoming year of
$6.00. The expected ROE is 18.0%. An appropriate required return on the stock is 14%. If
the firm has a plowback ratio of 70%, its intrinsic value should be …
8) Smart Investors, Inc., is expected to pay a dividend of $4.20 in the upcoming year.
Dividends are expected to grow at the rate of 8% per year. The riskless rate of return is
4% and the expected return on the market portfolio is 14%. Investors use the CAPM to
compute the required rate of return on the stock, and the constant growth DDM to
determine the intrinsic value of the stock. The stock is trading in the market today at
$84.00. Using the constant growth DDM and the CAPM, the beta of the stock is …
9) M&B Gold Mining Corporation is expected to pay a dividend of $6 in the upcoming year.
Dividends are expected to decline at the rate of 3% per year. The riskless rate of return is
5% and the expected return on the market portfolio is 13%. The stock of M&B Gold
Mining Corporation has a beta of -0.50. Using the constant growth DDM, the intrinsic
value of the stock is …
Part II: Detailed Questions
Explain why the following statements are true/false/uncertain.
a. Holding all else constant, a firm will have a higher P/E if its beta is higher.
b. P/E will tend to be higher when ROE is higher (assuming plowback is positive)
c. P/E will tend to be higher when the plowback rate is higher.
Heart Medical Inc. (HM) is a little-known producer of heart pacemakers. The earnings and
dividend growth prospects of the company are disputed by analysts. Paul is forecasting 5%
growth in dividends indefinitely. However, his brother Peter is predicting a 20% growth in
dividends, but only for the next three years, after which the growth rate is expected to drop to 4%
for the indefinite future. HM dividends per share are currently $3. The expected market return is
equal to 15% and the risk-free rate is 5%. Beta of a similar company is 0.5.
a) What is the intrinsic value of HM stock according to Paul?
b) What is the intrinsic value of HM stock according to Peter?
c) If both analysts predict a 12% return and the current price is $55 what action would you
recommend to somebody who is following estimates of Paul or Peter? Is this
recommendation entirely consistent? Make any assumptions you wish to justify your
This question requires data collection. You can find all numbers on finance.yahoo.com. The
questions concern Microsoft (ticker: MSFT).
(a) What are the current price and the current price-earnings ratio?
(b) What is the current plowback ratio?
(c) What is the growth rate of earnings for the next 5 years according to the analysts? Hint: look
for annual growth rates under “analyst estimates”
(d) What is the beta of MSFT? Hint: look for “key statistics”. If the risk-free rate (Rf) is
4% and the market risk premium E[RM −Rf ] is 8%, what is the required rate of return on MSFT
according to the CAPM?
(e) Assume that Microsoft will have earnings and dividends that will grow at the analysts
forecasted rate forever after; i.e., the Gordon growth model (GGM) applies. What is the price-
earnings ratio that the GGM predicts for Microsoft?
Question 4 (Adventure):
A small investment-consulting firm in the country of Transylvania is convinced that there are two
key common factors affecting stock returns. One is associated with a stock's dividend yield, the
other with its historic earnings growth rate. To this end, each of the 100 stocks in the
Transylvanian market has been analyzed, and assigned two numbers. The first, y(i) is the relative
yield of the stock. This is an integer number that ranges from a value of 100 (for the stock with
the highest yield) to 1 (for the stock with the lowest yield). The stock with the second-highest
yield has a y(i) of 99, and so on. The second number g(i) indicates the stock's relative growth
rate. Here, too the numbers are integers from 100 (for the stock with the highest historic growth
rate) to 1 for the stock with the lowest historic growth rate.
The consulting firm has also classified each stock based on its economic activity. Every stock
has been assigned to one (and only one) economic sector, basic industries (B), consumer goods
(C), finance (F), or technology (T).
The firm has hired you to implement this view in a factor model of security returns.
a) Write the equation that will characterize your model of the return-generating process. Please
define each term in sufficient detail to avoid any confusion.
b) Assume that the yield factor was positive last month. Does it mean that every stock with a
yield greater than the median yield outperformed every stock with a yield below the median
yield? Suppose that there are two stocks in the same industry with the same historic earnings
growth. Does this mean that the one with the higher yield outperformed the one with the lower
yield? What, if anything, can you say about the relative performance of high yield and low yield
stocks, based on the fact that the yield factor was positive?