Practice-Mid2s-S10 - Your Name:_ Practice Midterm 2...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Your Name:____________________ Practice Midterm 2 Financial Economics *********************************************************************** Descriptive and Conceptual Questions [6 pts] 1. Describe advantages of the two-stage FCFE model over the two-stage DDM model. The DDM cannot be used to estimate the value of a stock that pays no dividends. The FCFE model expands the definition of cash flows to include the balance of residual cash flows after all financial obligations and investment needs have been met. Thus the FCFE model explicitly recognizes the firm’s investment and financing policies as well as its dividend policy. In instances of a change of corporate control, and therefore the possibility of changing dividend policy, the FCFE model provides a better estimate of value. The DDM does not allow for the potential tax disadvantage of high dividends relative to the capital gains achievable from retention of earnings. [6 pts] 2. At Litchfield Chemical Corp. (LCC), a director of the company said that the use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price. a. Using a constant-growth dividend discount model as a basis of reference, evaluate the director’s statement. b. explain how an increase in dividend payout would affect each of the following (holding all other factors constant): i. Sustainable growth rate. ii. Growth in book value. Answer: a.This director is confused. In the context of the constant growth model [i.e., P 0 = D 1 /(k – g)], it is true that price is higher when dividends are higher holding everything else including dividend growth constant . But everything else will not be constant. If the firm increases the dividend payout rate, the growth rate g will fall, and stock price will not necessarily rise. In fact, if ROE > k , price will fall. b. (i) An increase in dividend payout will reduce the sustainable growth rate as less funds are reinvested in the firm. The sustainable growth rate (i.e., ROE × plowback) will fall as plowback ratio falls. (ii) The increased dividend payout rate will reduce the growth rate of book value for the same reason -- less funds are reinvested in the firm. [4 pts] 3. Write the equilibrium condition for reward-risk ratio under the CAPM and provide an interpretation. Answer: In the equilibrium the reward-risk ratio for all securities are equal to each other and that of the whole market. The appropriate measure of risk for any individual security is its covariance with the market while that of the market itself is variance. 2 ) ( ) , ( ) ( ) , ( ) ( M F M M j F j M i F i r r E r r Cov r r E r r Cov r r E σ - = - = -
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
[4 pts] 4. What are the determinants of the expected return of a security according to the CAPM?
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 06/05/2010 for the course ECON 134 taught by Professor Mojaver during the Spring '08 term at UC Davis.

Page1 / 6

Practice-Mid2s-S10 - Your Name:_ Practice Midterm 2...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online