chap007.doc finance

# chap007.doc finance - Solutions to Chapter 7 Valuing Stocks...

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Solutions to Chapter 7 Valuing Stocks 1. No, this does not invalidate the dividend discount model. The dividend discount model allows for the fact that firms may not currently pay dividends. As the market matures, and Amazon’s growth opportunities moderate, investors may justifiably believe that Amazon will enjoy high future earnings and will then pay dividends. The stock price today can still reflect the present value of the expected per share stream of dividends. 2. Dividend yield = Dividend/Price = DIV 1 /P 0 0.08 = 2.40/P 0 P 0 = \$30 3. The preferred stock pays a level perpetuity of dividends. The expected dividend next year is the same as this year’s dividend (\$8). a. \$8.00/0.12 = \$66.67 b. \$8.00/0.12 = \$66.67 c. Dividend yield = \$8/\$66.67 = 0.12 =12% Capital gains yield = 0 Expected rate of return = 12% 4. r = DIV 1 /P 0 + g = 8% + 5% = 13% 5. The value of a share of common stock equals the present value of dividends received out to the investment horizon, plus the present value of the forecast stock price at the horizon. But the stock price at the horizon date depends on expectations of dividends from that date forward. So, even if an investor plans to hold a stock for only a year or two, the price ultimately received from another investor depends on dividends to be paid after the date of purchase. Therefore, the stock’s present value is the same for investors with different time horizons. 6. a. P 0 = DIV 1 /(r - g) \$30 = \$3/(r - 0.04) r =0.14 = 14% b. P 0 = \$3/(0.165 - 0.04) = \$24 7-1

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7. The annual dividend is: \$2 × 4 = \$8 DIV 1 /P 0 = 0.048 \$8/P 0 = 0.048 P 0 = \$8/0.048 = \$166.67 8. weak, semistrong, strong, fundamental, technical 9. The statement is correct. The search for information and insightful analysis makes investor assessments of stock values as reliable as possible. Since the rewards accrue to the investors who uncover relevant information before it is reflected in stock prices, competition among these investors means that there is always an active search for mispriced stocks. 10. The two broad areas of investors’ behavioral biases are in their attitudes towards risk and their assessments of probabilities. Investors appear to be less averse to losses following substantial gains than they are to losses that follow other losses. Consequently, the early gains of the “dot-com bubble” may have led investors to increase their investments in dot-com stocks, leading to the tremendous gains leading up to March 2000. In addition, psychologists believe that investors make two mistakes in their assessment of stock market probabilities. First, when assessing the future of stock market performance, investors attach too much importance to the recent past, largely ignoring events of the more distant past. Second, investors suffer from overconfidence, believing that they are better stock pickers than they are in reality. These two biases reinforced the bubble prior to March 2000: overconfident investors attached too much importance to their experiences during the preceding five years.
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