may have access to additional information about the firm. It is important to note two mitigating factors in the United States. First, firms like Mr. Klein's are required to maintain a "Chinese Wall" between their brokerage and underwriting businesses to eliminate the transfer of any private information from the latter to the former. Second, firms are supposed to provide the same access to information to all of their analysts, eliminating selective disclosure to specific analysts. Disadvantages. Need for consistency between investment banking and brokerage operations. Since underwriters are selling the stock, it is unlikely that they will provide negative reports on their clients. The investment banking side of the business may therefore pressure Mr. Klein to make recommendations that are generally supportive of the firm's underwriting decisions. Desire for future investment banking business with the firm. Investment banking is likely a significant source of revenue for Mr. Klein's firm. Firms whose brokerage operations issue negative recommendations about a particular company are less likely to provide investment banking services for that company than those that issue positive recommendations. Thus, Mr. Klein's positive recommendation may be related either to his firm's desire to keep the company's future investment banking business or to the fact that its historical optimism made it initially an attractive underwriter for the client. Question 9. Intergalactic Software Company's stock has a market price of €20 per share and a book value of €12 per share. If its cost of equity capital is 15 percent and its book value is expected to grow at 5 percent per year indefinitely, what is the market’s assessment of its steady state return on equity? Determine the market's assessment of its steady state return on equity using the discounted abnormal earnings model. V= 1 + ⎡ROE - re⎤. B ⎣re- g ⎦where V = 20, b= 12, g= .05, and re= .15. Solving for ROE yields ROE = 0.217. Hence, the market estimate of Intergalactic Software Company's steady state return on equity is roughly 21.7 percent per year.
Solutions – Chapter 9 6 If the stock price increases to €35 and the market does not expect the firm's growth rate to change, what is the revised steady state ROE? Again using the discounted abnormal earnings model, the new V = 35 and all other variables remain the same. Solving the model, we get a revised steady state return on equity of 34.2 percent per year. If instead the price increase was due to an increase in the market's assessments about long-term book value growth, rather than long-term ROE, what would the price revision imply for the steady state growth rate? Let ROE equal 0.217 from the first part and solve for g instead. With ROE of 21.7 percent, a price of $35 suggests a steady state growth rate of 11.5 percent.
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