ch7_cool3 - C H A P T E R T WO ASSET CLASSES AND FINANCIAL...

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Your Name:____________________ Midterm 2 Financial Economics, Spring 2010 ***************************************************************************** * Descriptive and Conceptual Questions [4 pts] 1. Describe one weakness inherent in all DDMs. Answer: All DDMs are very sensitive to input values. Small changes in k or g can imply large changes in estimated intrinsic value. These inputs are difficult to measure. [9 pts] 2. Identify, within the context of the constant dividend growth model, how each of the following factors would affect the P/E ratio of stock ABC a. Risk (beta) of ABC b. Estimates growth rate of earnings and dividends c. Market risk premium Answer: a. The P/E ratio is a decreasing function of riskiness; as risk increases, the P/E ratio decreases. b. The P/E ratio is an increasing function of the growth rate of the firm; the higher the expected growth, the higher the P/E ratio. c. The P/E ratio is a decreasing function of the market risk premium. An increased market risk premium increases the required rate of return, lowering the price of a stock relative to its earnings. [6 pts] 3. Explain how an increase in dividend payout would affect each of the following (holding all other factors constant): a. Sustainable growth rate. b. Growth in book value. Answer: a. 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 x plowback) will fall as plowback ratio falls. b. 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] 4. Provide a formal definition of beta in a SML and explain what it measures.
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Answer: Formal definition: Beta describes the relative variability of returns. It measures the risk contribution of a security to the market portfolio relative to the variance of the market portfolio. It is a measure of the systematic risk
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This note was uploaded on 11/23/2010 for the course FINANCE 08FB40447 taught by Professor Raymond during the Spring '10 term at University of Manchester.

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ch7_cool3 - C H A P T E R T WO ASSET CLASSES AND FINANCIAL...

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