ASSIGNMENT | What price should the stock sell at?

Chapter 7:

15. Constant-Growth Model. A stock sells for $40. The next dividend will be $4 per share. If the rate of return earned on reinvested funds is a constant 15% and the company reinvests 40% of earnings in the firm, what must be the discount rate? (LO7-3)

16. Constant-Growth Model. Gentleman Gym just paid its annual dividend of $3 per share, and it is widely expected that the dividend will increase by 5% per year indefinitely. (LO7-3)

1. What price should the stock sell at? The discount rate is 15%.

Sol:  

• How would your answer change if the discount rate were only 12%? Why does the answer change?

Sol:

As the discount rate changed, the value of stock also changes.

18 . Constant-Growth Model. You believe that the Non-stick Gum Factory will pay a dividend of $2 on its common stock next year. Thereafter, you expect dividends to grow at a rate of 6% a year in perpetuity. If you require a return of 12% on your investment, how much should you be prepared to pay for the stock? (LO7-2)

Sol:

Chapter 11:

1. Stock Market History. Use the data in Tables 11.1 and 11.4 to answer these questions: (LO11-1)

a.  What was the average rate of return on large U.S. common stocks from 1900 to 2013?

      Sol:

• What was the average risk premium on large stocks?

 Sol:

• What was the standard deviation of returns on the market portfolio?

Sol:

2. Maturity Premiums. Investments in long-term government bonds produced a negative average return during the period 1977–1981. How should we interpret this? Did bond investors in 1977 expect to earn a negative maturity premium? What do these 5 years’ bond returns tell us about the normal future maturity premium? (LO11-1)

Sol:

3. Risk Premiums. What will happen to the opportunity cost of capital if investors suddenly become especially conservative and less willing to bear investment risk? (LO11-1)

Sol:

4. Risk Premium. If the stock market return next year turns out to be −20%, will our estimate of the “normal” risk premium increase or decrease? Does this make sense?

Sol:  

5. Risk Premiums and Discount Rates. Top hedge fund manager Sally Buffit believes that a stock with the same market risk as the S&P 500 will sell at year-end at a price of $50. The stock will pay a dividend at year-end of $2. What price should she be willing to pay for the stock today? Assume that risk-free Treasury securities currently offer an interest rate of 2%. Use Table 11.1 to find a reasonable discount rate. (LO11-1)

Sol: