AFM273 Chapter : 9 _ VALUING STOCKS.docx

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tealmosquito387

26 Nov 2014

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM273

Professor

Andrew Ecclestone

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Document Summary

Valuing the price of a stock by using predicated dividends and discounting them back to present value. If value from dividend discount model is higher than what share currently trading at, then the stock is undervalued. Law of one price states amount received in dividends and from future selling price of stock depends on investor"s investment horizon, which is equal to the value of the stock. , undervalued and investors are quick to buy; driving prices up (positive npv investment opportunity: current stock prices > amount po. , overstated and selling it cause stock prices to quickly fall. Dividend yields, capital gains, and total returns r. Total return of stock = dividend yield + capital gain rate: dividend yield: expected annual dividend of stock dividend by its current price, capital gain: p1 p2. = expected sale price purchase price: capital gain rate: capital gain expressed as a percentage, expected total return of stock = equity cost of capital.

Related Questions

Consider the following statement to answer Questions i-iv: You manage a risky portfolio with an expected rate of return of 17% and a standard deviation of27%. The Treasury-bill rate is 7%. (i) One of your clients chooses to invest 70% of a portfolio in your fund and 30% in a T-bill moneymarket fund. What is the expected value and standard deviation of the rate of return on yourclientâs portfolio?(2 marks) (ii) Suppose that your client decides to invest in your portfolio a proportion y of the total investmentbudget so that the overall portfolio will have an expected rate of return of 15%. (a) What is the proportion y? (Hint: Use CAPM formula) (b) Further suppose that your risky portfolio includes the following investments in the givenproportions: Stock A (27%), Stock B (33%), and Stock C (40%). What are your clientâsinvestment proportions in your three stocks and the T-bill fund?(2 marks) (iii) Now suppose that your client prefers to invest in your fund a proportion ythat maximizes theexpected return on the overall portfolio subject to the constraint that the overall portfolioâsstandard deviation will not exceed 20%. (a) What is the investment proportion, y? (b) What is the expected rate of return on the overall portfolio?(2 marks) (iv) Suppose that your clientâs degree of risk aversion is A = 3.5. What proportion, y, of the totalinvestment should you suggest that he invest in your fund?(2 marks) (v) The market price of a security is $40. Its expected rate of return is 13%. The risk- free rate is 7%and the market risk premium is 8%. What will be the market price of the security if itscovariance with the market portfolio doubles (and all other variables remain unchanged)?Assume that the stock is expected to pay a constant dividend in perpetuity.(2 marks) QUESTION 2: OMEGA Currently Omega Corporationâs shares are selling at $60 per share and company is paying $5 per share dividend. Dividends are expected to grow at an annual rate of 3% for foreseeable future. Required rate of return for investors is 12% At the same time, Heller Corporationâs shares are selling at $58 per share and company is paying $4 per share dividend. Dividends are expected to grow at an annual rate of 5% for foreseeable future. Required rate of return for investors is 12% a) Calculate the current value of each stock on the basis of Dividend Discount Model. b) On the basis of above calculation, determine either each stock is overvalued or undervalued. (5 marks)

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5. The companyâs common stock is going to pay a dividend is $2.00 per share after one year. Dividends are expected to grow at 10 percent per year for 2 years after that ($2.20 two years from now, and $2.42 3 years from now), and 4% thereafter.

The expected market return is 6%, your stock has a beta of 1.2. The return on riskless government bonds is 2%.

1. Assuming CAPM is correct, what should be the price of the stock?

2. Suppose the market price of the stock is $30 (different from the price that CAPM says it should be), what would you tell the investors about investing in the stock?

Concept Check: Capital is acquired in the marketplace. For many of us it is in the form of loans; publicly traded companies have access to debt in the form of bonds and equity in the form of stocks. In any instance we are being judged as to how much of a risk is the capital at for not being recovered. Risks include (but are not limited to); inflation or the erosion of the value of my money; opportunity costs in the form of interest free government securities, compensation for the chance of not being paid back (default risk), compensation for the length of time the capital is at risk (maturity) and compensation for the ability to be able to turn the investment of capital into cash by trading it or converting the obligation (liquidity risk).

Helpful Hint: We need to look at this from the market perspective of what is a fair rate of return for the investment compared to alternatives available.

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QUESTION 2 You are a corporate finance analyst at a investment management firm, which is looking at making an investment into the company called Boston Turkey Inc. The company, Boston Turkey Inc., has been in existence for only two years, and its stock is currently trading at $20 per share (There are 100,000 shares outstanding.) The following are the most recent financial statements of the company: Further company and market information is indicated below: Current Numbers:

Earnings per share = $ 2.40

Net Income = $240,000

Dividends per share = $ 1.00

Interest Expenses = $100,000

Market price per share = $ 20

Market Value of Debt = 1,250,000

Number of shares = 100,000

Book Value of Equity = $1,500,000

Cash is only Current Asset

Tax Rate = 40%

Boston Turkey expects its revenues to grow 10% next 5 years, and its expenses to remain at the same percentage as indicated in the base year. The depreciation and interest expenses will remain unchanged at $100,000 next year. The working capital, as a percentage of revenue, will remain unchanged. Develop the next 5 years worth of income statement and common size it to the base year Income Statement-

BASE YEAR Revenues$ 1,000,000

Expenses$400,000

Depreciation$100,000

EBIT$500,000-

Interest Expense$100,000

Taxable Income$400,000-

Tax$160,000

Net Income$240,000 i

Assume in your revision year that the company will maintain the perpetual net income for the going remaining years at a market discount rate of 12%. The firm expects to maintain the dividend payout policy relative to its net income each year going forward until the final year of the investment whereafter it will pay a fixed $1.85 per share into perpetuity Questions to answer:

1.You are looking to invest $200,000 for the firm for a period of 5 years, how many shares do you purchase a part of the purchase price?

2.What is the dividend payout percentage for the company in the base year?

3.What is the nominal dollar value of dividend earnings for the company in the third year of the investment?

4.If the company is selling for a price to earning ratio of 8.33 in the base year and that P/E multiple is maintained till the 5th year, what will be the price of the stock in the fifth year of the investment horizon?

5.If your investment firm has a 8% preputial discount rate relating to the firm dividend for the perpetuity value of the company, what is the per share value of the company in the 5th year of the investment horizon?

6.If you firm has a hurdle rate of 10% to the make the investment, would you make the investment?

7.What is the NPV value for this investment at a 10% discount rate?

8.What is the IRR for this investment?

9.What is the Enterprise Value of the investment in the base year?

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AFM273 Chapter : 9 _ VALUING STOCKS.docx

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