Assignment answer 1 - asset is worth less if inflation...

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Economics 720 Fall 2010 MSFA Program John Gonzales Assignment #1 Answers 1. You are given the following information for company X and the financial markets. (a) r S = 6.46 + 1.4(14 – 6.46) = 17.02%. P 0 = 2.16/(.1702 - .08) = $23.95. (b) The CGY = g, i.e. the stock price must grow by 8%, so P 1 = 23.95(1 + .08) = $25.87. In one year the constant grown model holds. So, using the next dividend, P 1 = [2.16(1 + .08)]/(.1702 - .08) = $25.87. DY = 2.16/23.95 = 9.02%%. CGY = (25.87 – 23.95)/23.95 = 8.00%; r S = 9.02% + 8.00% = 17.02%. (c) P 10 = D 11 /(r S – g) = [2.00(1 + .08) 11 ]/(.1702 - .08) = $51.70. (d) Now, r S = [6.46 + 1.5] + 1.4[(14 + 1.5) – (6.46 + 1.5)] = 18.52%. The rate of return always includes compensation for inflation, so the rate of return must increase by 1.5%. Now, P 0 = 2.16/(.1852 - .08) = $20.53. Price decreases because any financial
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Unformatted text preview: asset is worth less if inflation increases. Alternatively, the rate of return on bonds increases as market interest rates always increase if inflation increases. The return on stocks must increase if bond returns increase. A higher return on stocks can be achieved only if stock prices fall. (e) Now, r M = 13%, so r S = 6.46 + 1.4(13 6.46) = 15.62%. If investors become less risk averse regarding stocks, less compensation is required to hold stocks. So, r S decreases. Now, P = 2.16/(.1562 - .08) = $28.35. Price increases because investors are now willing to pay more for stocks since they are viewed as being less risky. (f) The actual return must fall from 18.60% to 17.02%. In order to have a lower return, the purchase price must increase. So, at this moment the stock is undervalued....
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