Chapter6

Equity:ConceptsandTechniques

11. a.

IntrinsicP/Eratio

P0 1
b(ROE r )
1
.
E1 r
r ROE b

Inthiscase,b0,becausethecompanypaysoutallitsearnings.So,P0 /E 11/r1/0.137.69.
b. Again,P0 /E 11/r1/0.137.69.
c. Itisclearfromtheexpressioninpart(a)thatifb0,theintrinsicP/Evalueisindependentof
ROE.Tofurtherexplorethis,realizethattheintrinsicP/EvaluecanalsobeexpressedasP0 /E 1
(1/r)FFG,wherethefranchisefactorisFF(ROEr)/(ROEr)or1/r1/ROE,andthe
growthfactorisGg/(rg).Ifb0,theng0,andtherefore,thegrowthfactorG0.Thus,
regardlessofhowbigtheROEandconsequentlythefranchisefactorFFis,thefranchise
value,FFG,iszero,andtheintrinsicP/Evalueissimply1/r.
d. Again,P0 /E 11/r1/0.137.69.
e. Inpart(d),ROEr13%.Itisclearfromtheexpressioninpart(a)thatifROEr,theintrinsic
P/Evalueisindependentoftheretentionratio,b.Tofurtherexplorethis,letusagainlookatthe
expressionforintrinsicP/Evaluediscussedinpart(c).IfROEr,thenthefranchisefactor
FF0.Thus,regardlessofhowlargetheretentionratioandconsequentlythegrowthfactorG
is,thefranchisevalue,FFG,iszero,andtheintrinsicP/Evalueissimply1/r.
20. a.

R f 4%, RPw 5%, andRPSFr 1%.

So E ( Ri ) 4% 1 5% 2 1%

Accordingly,
E ( RA ) 4% 1 5% 1 1% 10%
E ( RB ) 4% 1 5% 0 1% 9%
E ( RC ) 4% 1.2 5% 0.5 1% 10.5%
E ( RD ) 4% 1.4 5% 0.5 1% 10.5%

b. Stocksthatshouldbepurchasedarethosewithaforecastedreturn,higherthantheirtheoretical
expectedreturn,giventhestocksriskexposures.Becausetheforecastedreturnsgivenintheproblem
arethereturnsinSwissfrancs,weneedtoconvertthemtodollarreturnsfirst.WeexpecttheSwiss
franctoappreciaterelativetothedollarby2percent.Therefore,usingalinearapproximation,the
dollarreturnisthereturninSwissfrancs2percent.Thefollowingtablesummarizestheforecasted
returnsinfrancsandindollars,andthetheoreticalexpectedreturns
indollars[computedinPart(a)].
StockA StockB StockC
Forecastedreturn(infrancs)
Forecastedreturn(indollars)
Theoreticalexpectedreturn(indollars)

8%
10%
10%

9%
11%
9%

11%
13%
10.5%

StockA
7%
9%
10.5%

Lookingatthistable,wefindthatthebrokerforecastssuperiorreturnsforStocksBandC.
Therefore,theyshouldbebought.Conversely,StockDshouldbesold.

Chapter8
TheCaseforInternationalDiversification

3. a.

Foreachportfolio,expectedreturniscalculatedusingEquation9.1,andportfoliostandard
deviationiscalculatedusingEquation9.2.Expectedreturnsandstandarddeviationsforthe
portfoliosarelistedinthefollowingtable.
When = 0.5:
Investedin
Asset1

Investedin
Asset2

PortfolioExpected
Return

Portfolio
Risk

100%

0%

10.00%

14.00%

80%

20%

11.20%

13.10%

60%

40%

12.40%

12.86%

50%

50%

13.00%

13.00%

40%

60%

13.60%

13.31%

20%

80%

14.80%

14.41%

0%

100%

16.00%

16.00%

b. Foreachportfolio,expectedreturniscalculatedusingEquation9.1,andportfoliostandard
deviationiscalculatedusingEquation9.2.Expectedreturnsandstandarddeviationsforthe
portfoliosarelistedinthefollowingtablesforvariouscorrelations.
When = 1.0:
Investedin
Asset1

Investedin
Asset2

PortfolioExpected
Return

Portfolio
Risk

100%

0%

10.00%

14.00%

80%

20%

11.20%

8.00%

60%

40%

12.40%

2.00%

50%

50%

13.00%

1.00%

40%

60%

13.60%

4.00%

20%

80%

14.80%

10.00%

0%

100%

16.00%

16.00%

When = 0:
Investedin
Asset1

Investedin
Asset2

PortfolioExpected
Return

Portfolio
Risk

100%

0%

10.00%

14.00%

80%

20%

11.20%

11.65%

60%

40%

12.40%

10.56%

50%

50%

13.00%

10.63%

40%

60%

13.60%

11.11%

20%

80%

14.80%

13.10%

0%

100%

16.00%

16.00%

When = 1.0:
Investedin
Asset1
100%

Investedin
Asset2
0%

PortfolioExpected
Return

Portfolio
Risk

10.00%

14.00%

c.

80%

20%

11.20%

14.40%

60%

40%

12.40%

14.80%

50%

50%

13.00%

15.00%

40%

60%

13.60%

15.20%

20%

80%

14.80%

15.60%

0%

100%

16.00%

16.00%

ThegraphsforParts(a)and(b)illustratethat,holdingallelseconstant,lowercorrelations
translateintolowerlevelsofportfoliorisk,withoutsacrificingexpectedreturn.

5.a. Ifthecorrelationbetweenstockmarketreturnsandexchangeratemovementswereequaltozero,the
dollarvolatilityoftheGermanstockmarketwouldbe

2f 2 s2 2 s (18.2)2 (11.7)2 2(0)(18.2)(11.7) 468.13

f 21.64%
b. Becausetheactualdollarvolatilityisonly20.4percent,weconcludethatthecorrelationbetween
stockmarketreturnsandexchangeratemovementsisnegative.