FIN500 Assignment 3 (individual work) Total points: 12

Part I. Multiple choice questions/problems:

1. Other things equal, when residual cash flows are low, stock values will be
B. low.
2. Investors buy stock at the
C. quoted ask price.
3. Which of the following statements is most correct?
A. The stock valuation model, P0 = D1/ (i - g), can be used for firms which have
negative growth rates.
4. Company J and Company K each recently reported the same earnings per share (EPS).
Company Js stock, however, trades at a higher price. Which of the following statements
is most correct?
A. Company J must have a higher P/E ratio.
5. Value a Constant Growth Stock Financial analysts forecast Best Buy Company
(BBY) growth for the future to be 13 percent. Their recent dividend was $0.49. What is
the value of their stock when the required rate of return is 14.13 percent?
D. $49.00
P0

= D0(1+g)/(i-g)

= .49(1+.13)/(.1413-.13)
= 49.00
6. P/E Ratio Model and Future Price Walmart (WMT) recently earned a profit of $3.13
per share and has a P/E ratio of 14.22. The dividend has been growing at a 12.5 percent
rate over the past few years. If this growth continues, what would be the stock price in
five years if the P/E ratio remained unchanged?
C. $80.20
Pn
P5

= (P/e) * E0 * (1+g)n
= (14.22) * 3.13 * (1+.125)5
= 80.2059

7. Expected Return The Buckle (BKE) recently paid a $0.90 dividend. The dividend is
expected to grow at a 19 percent rate. At the current stock price of $43.17, what is the
return shareholders are expecting?
C. 21.48%
i

= D1/P0 + g
= D0(1 + g)/P0 + g
= .90(1+.19)/43.17 + .19
= .2148

8. This is the interest rate that would exist on a default free security if no inflation were
expected.
B. real interest rate
9. This theory argues that individual investors and financial institutions have specific
maturity preferences, and to encourage buyers to hold securities with maturities other
than their most preferred requires a higher interest rate.
B. Market Segmentation Theory
10. Unbiased Expectations Theory Suppose that the current one-year rate (one-year
spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2,
3, and 4, respectively) are as follows:

Using the unbiased expectations theory, what is the current (long-term) rate for four-yearmaturity Treasury securities?
A. 6.00%
R4

= [(1+.05)(1+.038)(1+.043)(1+.058)]1/4 1
= [1.2026]1/4 1
=.059971 or 6%

Part II. Problems.

1. Non-Constant growth stock Valuation Stewart Industries just paid a $3.00 per share
dividend on its common stock yesterday (i.e., D0 = $3.00). The dividend is expected to
grow 20 percent a year for the next four years, after which time the dividend is expected
to grow at a constant rate of 5 percent a year for ever. The stocks beta is 1.5, the riskfree rate of interest is 2 percent, and the rate of return on the market portfolio is 10
percent.
a. What is the require rate of return on the stock (1 point)?
Required return

= Rf + (RM Rf)
= .02 + 1.5(.1 - .02)
=.14 = 14%

b. What is the price of the stock at the end of year 4 (1.5 points)
D0 = $3.00
D1 = 3 * 1.2 = 3.6
D2 = 3.6 * 1.2 = 4.32
D3 = 4.32 * 1.2 = 5.184
D4 = 5.184 * 1.2 = 6.22
D5 = 6.22 * 1.05 = 6.53
P4 = D5/(i g2)
= 6.533184/(.14 - .05)
= 6.533184/.09 = $72.58
c. What should be the stock price today (1.5 points)
D0 = $3.00
g1 = .2
g2 = .05
i = .14
n=4
P0 = D0(1+g1)/(1+i) + D0(1+g1)2/(1+i)2 + D0(1+g1)3/(1+i)3
+ [D0(1+g1)4 + D0(1+g1)4(1+g2)/(i-g2)]/(1+i)4
P0 = 3(1.2)/(1.14) + 3(1.2)2/(1.14)2 + 3(1.2)3/(1.14)3
+ [3(1.2)4 + 3(1.2)4(1.05)/(.14-.05)]/(1.14)4
P0 = 3(1.2)/1.14 + 3(1.44)/1.2996 + 3(1.728)/1.481544
+ [(3)(2.0736) + 3(2.0736)(1.05)/(.09)]/(1.68896)
P0 = 3.157895 + 3.3241 + 3.499052
+ [6.2208 +72.576]/(1.68896)
P0 = 9.981047 + $46.65403
P0 = $56.64

2. Determinants of Interest Rate for Individual Securities You are considering an

investment in 30-year bonds issued by a corporation. The bonds have no special
covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 4.25
percent. Your broker has determined the following information about economic activity
and the corporation bonds:
Real interest rate = 3.25%
Default risk premium = 2.00%
Liquidity risk premium = 0.40%
Maturity risk premium = 1.25%
What is the inflation premium (0.5 point)?
Expected (IP) = I RIR = 4.25 3.25 = 1.00%
What is the fair interest rate on the corporation's 30-year bonds (0.5 point)?
i

= (IP + RIR + DRP + LRP + SCP + MP)

= (1.00 + 3.25% + 2.00% + .40% + 0 + 1.25%)
= 7.9%

3. Unbiased Expectations Theory Suppose we observe the following rates: 1R1 = 5.75%,
1R2 = 6.5%. If the unbiased expectations theory of the term structure of interest rates
holds, what is the one-year interest rate expected one year from now, E(2r1) (1 point)?
R2 = [(1 + 1R1)(1 + E(2r1))]1/2 1
1/2
1R2 + 1 = [(1 + 1R1)(1 + E(2r1))]
(1R2 + 1)2/(1 + 1R1) = (1 + E(2r1))
E(2r1) = (1R2 + 1)2/(1 + 1R1) 1
1

E(2r1) = (1R2 + 1)2/(1 + 1R1) 1

= (1.065)2/1.0575 1
= 1.134225/1.0575 1
= 1.072553 1 = 7.26%
4. Forecasting Interest Rates On May 23, 20XX, the existing or current (spot) one-year,
two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:

Using the unbiased expectations theory, what is the one-year forward rate on zero-coupon
Treasury bonds for year four as of May 23 (i.e., , 4f1) , 20XX (1 point)?
= [(1+1RN)N/(1+1RN-1)N-1] 1
Nf1
= [(1+1R4)4/(1+1R3)3] 1
4f1
= [(1.0645)4/(1.0625)3] 1
= [1.284052/1.199463] 1
= 1.070523 1 = 7.05%