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Unformatted text preview: IMSE3010 Financial Engineering Lecture 5 Common Stocks Discrete Time Market Model Miao Song Dept of Industrial & Manufacturing Systems Engineering 2/15/2011 2 2/15/2011 2 Review of Lecture 4 ¡ Common Stocks ¢ Discounted Cash Flow with Constant and MultiStage Growth ¢ EPS, BV, ROE, payout / plowback ratio 2/15/2011 3 2/15/2011 3 Agenda ¡ Common Stocks ¢ P/E and Growth Opportunity ¡ Discrete Time Market Model ¢ Binomial Tree ¢ Principle of No Arbitrage 2/15/2011 4 2/15/2011 4 Example ¡ Texas Western (TW) is expected to earn $1.00 next year. Book value per share is $10.00 now. TW plans an investment program which will increase net book assets by 8% per year. Earnings are expected to grow proportionally. The investment is financed by retained earnings. The discount rate is 10%, which is assume to be the same as the rate of return on new investments. ¡ Price of TW’s share if ¢ TW expands at 8% forever ¢ TW’s expansion slows down to 4% after year 5 2/15/2011 5 2/15/2011 5 Summary of TW Example ¡ Relationship between EPS, BV, ROE, payout / plowback ratio ¢ ROE = EPS / BVPS ¢ Dividend = p × EPS ¢ Retained Earnings = b × EPS ¢ Retained Earnings = Increase in BVPS ¢ g = ROE × b if ROE is constant ¡ Why P are the same for continuing expansion and twostage expansion? ¢ ROE = r = 10%, i.e., ROE is equal to the required return on capital 2/15/2011 6 2/15/2011 6 Growth Opportunities and Growth Stocks ¡ Growth opportunities are investment opportunities that earn expected returns higher than the required rate of return on capital ¡ Stocks of companies that have access to growth opportunities are considered growth stocks ¡ Are these growth stocks? ¢ A stock with growing EPS ¢ A stock with growing dividends ¢ A stock with growing assets ¢ A stock with EPS growing slower than required rate of return ¢ A stock with DPS growing slower than required rate of return 2/15/2011 7 2/15/2011 7 Example of Growth Stock ¡ ABC Software has the following data: ¢ Expected EPS next year is $8.33 ¢ Payout ratio is 0.6 ¢ ROE is 25% ¢ Cost of Capital is r = 15% ¡ D 1 & g? 2/15/2011 8 2/15/2011 8 Example of Growth Stock (cont.) ¡ Following a nogrowth policy (g = 0 and p = 1), what is P ? ¡ Following the growth policy, what is P ?...
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This note was uploaded on 12/09/2011 for the course IMSE 0301 taught by Professor Song during the Spring '11 term at HKU.
 Spring '11
 SONG

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