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Unformatted text preview: CARNEGIE MELLON UNIVERSITY Tepper School of Business INTRO FINANCE FIN 70391 Prof. Spencer Martin Solution Set 3: From Present Value to Portfolios A Multiple Choice Warmup 1. Consider a stock that will pay a dividend of $1 per share one year from now. The dividend (paid annually) will then increase by 10% annually forever. Suppose that the discount rate is 12% and that the stocks return on reinvested earnings is 15%. What is the EPS (earnings per share) one year from now? $3.00 k = . 10 /. 15 = 2 / 3 2. Consider a stock that will pay a dividend of $1 per share one year from now. The dividend (paid annually) will then increase by 10% annually forever. Suppose that the discount rate is 12% and that the stocks return on reinvested earnings is 15%. What is the NPVGO? $25 P = D 1 r g = 1 . 12 . 10 = $50 NPV GO = P EPS r = 50 3 . 12 = $25 3. Consider a stock that will pay a dividend of $1 per share one year from now. The dividend (paid annually) will then increase by 10% annually forever. Suppose that the discount rate is 12% and that the stocks return on reinvested earnings is 15%. What is the dividend yield ( D 1 /P )? None of the above r = D/P + g, 12% = 2% + 10% 4. What is the relationship between the earningsprice ratio ( E/P ) and the discount rate (opportunity cost of capital r )? None of the above. P = E r + NPV GO P/E = 1 r + NPV GO E E/P = 1 1 r + NPV GO E So E/P = r if NPV GO is zero... 1 5. The finance director of a publicly traded company is considering increasing the plowback rate of the firm. The opportunity cost of capital is 9%, there are no taxes or transaction costs and there is an infinite supply of projects available. All such projects will return 9%. The following are comments that emerged from the directors meeting. Which of the following is/are correct? We should not increase the plowback rate because, although this will increase the NPVGO, investors put a higher emphasis on near cash flows. FALSE. Discounting already puts the higher emphasis on near cash flows. NPVGO is not going to increase, either, since r * = r . Although dividends will temporarily decrease, the NPVGO will increase. Since our company looks after the long term interests of shareholders we should put more emphasis on the NPVGO and increase the plowback rate. FALSE. Dividend growth will increase, since g = k r * . NPVGO is not going to increase, though, since r * = r . We know that longterm investors such as pension funds do not hold a high proportion of our stock. Therefore our investors are more demanding of short term cash flows than average, and we should therefore put less emphasis on the NPVGO and not increase the plowback rate....
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 Spring '08
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