Assignment 3 Solutions

# Assignment 3 Solutions - M GCR 341 Finance 1 Summer 2010...

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MGCR 341: Finance 1 Summer 2010 Vadim di Pietro Assignment 3 Solutions 1) Topic: Equity Valuation True or False, no explanation required. For the questions below, assume that a fraction p of earnings are paid out as dividends, and thus the value of the S&P 500 is given by P = p (EPS 1 )/(r E -g), where r E , the required rate of return on the market is given by the CAPM: r E = r f + (1)(E[r m ]-r f ). (Note, the beta of the market is 1.) In each case below, assume p remains unchanged . The answers to parts a) through e) are all TRUE. This follows simply from applying the above formula. If the math/intuition is not clear to you, then ask me to explain during office hours. a) If 1) the risk free rate increases, 2) the market risk premium E[r m ]-r f remains unchanged, and 3) g remains unchanged, then the S&P 500’s PE ratio will fall (i.e., earnings yields will rise). b) If g increases, and everything else remains unchanged, the S&P 500’s PE ratio will rise (i.e., earnings yields will fall). c) Assume inflation expectations increase by 2%. Assume this causes the risk free rate to increase by 2%. Also, assume this causes growth expectations to increase by 2% (since equity earnings are derived from real assets). Under these assumptions, and holding the market risk premium constant, the S&P 500’s PE ratio and earnings yield will remain unchanged when inflation expectations increase. d) Holding all else equal, if the market risk premium increases, the S&P 500’s PE ratio will fall (i.e., earnings yields will rise). e) Same assumptions as in part c, except assume the market risk premium increases when inflation increases. Under this new assumption, the S&P 500’s PE ratio will fall (i.e., earnings yields will rise) when inflation expectations increase.

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2) Topic: Corporate Bond Valuation Assume the risk free rate is constant at 2% for all maturities, the market risk premium is 5%, and the CAPM holds. Corporate bond A is a zero coupon bond with \$100 face value, 3 years to maturity, and a beta of 0.8. Assume the recovery rate on bond A is 30% if a default occurs, and that the default probability in each year is 5%. a) What are the fair price and credit spread of bond A at t = 2 if the bond did not default in the first two years? If the bond has not already defaulted, then at t = 2, it is a one year zero coupon
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## This note was uploaded on 08/31/2010 for the course MANAGEMENT MGCR 341 taught by Professor Jassim during the Summer '09 term at McGill.

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Assignment 3 Solutions - M GCR 341 Finance 1 Summer 2010...

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