Lecture 5

Lecture 5 - IMSE3010 Financial Engineering Lecture 5 Common...

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IMSE3010 Financial Engineering Lecture 5 Common Stocks iscrete Time Market Model Discrete Time Market Model Miao Song Dept of Industrial & Manufacturing Systems Engineering
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eview of Lecture 4 Review of Lecture 4 Common Stocks Discounted Cash Flow with Constant and Multi-Stage Growth EPS, BV, ROE, payout / plowback ratio 2/15/2011 2
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genda Agenda Common Stocks P/E and Growth Opportunity Discrete Time Market Model inomial Tree Binomial Tree Principle of No Arbitrage 2/15/2011 3
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xample Example Texas Western (TW) is expected to earn $1.00 next year. Book value per share is $10.00 now. W plans an investment program which will 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 e same as the rate of return on new 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 4
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ummary of TW Example Summary of TW Example Relationship between EPS, BV, ROE, payout / plowback ratio OE = EPS / BVPS ROE = EPS / BVPS Dividend = p × EPS etained Earnings = b PS Retained Earnings b × EPS Retained Earnings = Increase in BVPS = ROE × if ROE is constant gObO s c o s a 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 2/15/2011 5
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Growth Opportunities and Growth Stocks Growth opportunities are investment opportunities that earn expected returns higher than the required rate of return on capital p Stocks of companies that have access to growth opportunities are considered growth stocks Are these growth stocks? A stock with growing EPS stock with growing dividends 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 6
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xample of Growth Stock 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? D 1 = p × EPS = (0.6)(8.33) = $5.00 g = b × ROE = (0.4)(0.25) = 0.10 2/15/2011 7
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xample of Growth Stock (cont ) Example of Growth Stock (cont.) Following a no-growth policy (g = 0 and p = 1), what is P 0 ? ollowing the growth policy what is P Following the growth policy, what is P 0 ? Why are these two values different? rowth opportunity which offers a return of Growth opportunity, which offers a return of 25%, higher than the required rate of return 15% 2/15/2011 8
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xample of Growth Stock (cont ) Example of Growth Stock (cont.) t t = 1 At t = 1 What is the investment at t?
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Lecture 5 - IMSE3010 Financial Engineering Lecture 5 Common...

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