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HW5s-S10-2

# HW5s-S10-2 - Solution to Problem Set 5 ECN 134 Financial...

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Solution to Problem Set 5 ECN 134 Financial Economics Prof. Farshid Mojaver Questions on Stock Valuation 2 1. The market consensus is that Analog Electronic Corporation has an ROE=9%, has a beta of 1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3. This year’s earnings were \$3 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 14%, and T-bills currently offer a 6% return. a. Find the price at which analog stock should sell. b. Calculate the P/E ratio. c. Calculate the present value of growth opportunities. d. Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. The market is still unaware of this decision. Explain why 0 V no longer equals 0 P and why 0 V is greater or less than 0 P . a. k = r f + β[Ε (r M ) – r f ] = 6% + 1.25(14% – 6%) = 16% g = 2/3 × 9% = 6% D 1 = E 0 (1 + g) (1 – b) = \$3(1.06) (1/3) = \$1.06 60 \$10. 0.06 0.16 \$1.06 g k D P 1 0 = - = - = b. Leading P 0 /E 1 = \$10.60/\$3.18 = 3.33 Trailing P 0 /E 0 = \$10.60/\$3.00 = 3.53 c. 275 . 9 \$ 16 . 0 18 . 3 \$ 60 . 10 \$ k E P PVGO 1 0 - = - = - = The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than the market capitalization rate (16%). d. Now, you revise b to 1/3, g to 1/3 × 9% = 3%, and D 1 to: E 0 × 1.03 × (2/3) = \$2.06 Thus: V 0 = \$2.06/(0.16 – 0.03) = \$15.85 V 0 increases because the firm pays out more earnings instead of reinvesting a poor ROE. This information is not yet known to the rest of the market.

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2. Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA, head of the research department, gathered the following fundamental industry and market data to help in his analysis: Forecast industry earnings retention rate 40% Forecast industry return on equity 25% Industry beta 1.2 Government bond yield 6% Equity risk premium 5% a. Compute the price-to-earnings (P 0 /E 1 ) ratio for the industry based on this fundamental data. b. Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathered the following economic and market data. Fundamental Factors Country A Country B Forecasted growth in real GDP 5% 2% Government bond yield 10% 6% Equity risk premium 5% 4% Determine whether each of these fundamental factors would cause P/E ratios to be generally higher for Country A or higher for Country B. a.The industry’s estimated P/E can be computed using the following model: P 0 /E 1 = payout ratio/(r - g) However, since r and g are not explicitly given, they must be computed using the following formulas: g ind = ROE × retention rate = 0.25 × 0.40 = 0.10 r ind = government bond yield + ( industry beta × equity risk premium) = 0.06 + (1.2 × 0.05) = 0.12 Therefore: P 0 /E 1 = 0.60/(0.12 - 0.10) = 30.0 b. i. Forecast growth in real GDP would cause P/E ratios to be generally higher for Country A. Higher expected growth in GDP implies higher earnings growth and a higher P/E.
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