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Lecture 5 no sol

# Lecture 5 no sol - IMSE3010 Financial Engineering Lecture 5...

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IMSE3010 Financial Engineering Lecture 5 Common Stocks Discrete Time Market Model Miao Song Dept of Industrial & Manufacturing Systems Engineering

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2/15/2011 2 Review of Lecture 4 Common Stocks Discounted Cash Flow with Constant and Multi-Stage Growth EPS, BV, ROE, payout / plowback ratio
2/15/2011 3 Agenda Common Stocks P/E and Growth Opportunity Discrete Time Market Model Binomial Tree Principle of No Arbitrage

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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 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 0 are the same for continuing expansion and two-stage expansion? ROE = r = 10%, i.e., ROE is equal to the required return on capital

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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 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?

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2/15/2011 8 Example of Growth Stock (cont.) Following a no-growth policy (g = 0 and p = 1), what is P 0 ? Following the growth policy, what is P 0 ? Why are these two values different?
2/15/2011 9 Example of Growth Stock (cont.) At t = 1 What is the investment at t?

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Lecture 5 no sol - IMSE3010 Financial Engineering Lecture 5...

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