Chapter 7
3. IBX stock is trading for $35 on the NYSE and $33 on the Tokyo Stock Exchange. Assume that the costs of buying and selling the stock are negligible.
a. How could you make an arbitrage profit?
b. Over time what would you expect to happen to the stock prices in New York and
Tokyo?
c. Now assume that the cost of buying or selling shares of IBX is 1% per transaction. How does this affect your answer?
4. Suppose you live in the state of Taxachusetts, which has a 16% sales tax on liquor. A neighboring state called Taxfree has no tax on liquor. The price of a case of beer is $25 in Taxfree and it is $29 in Taxachusetts.
a. Is this a violation of the Law of One Price?
b. Are liquor stores in Taxachusetts near the border with Taxfree going to prosper?
15. The P/E ratio of ITT Corporation is currently 6 while the P/E ratio of the S&P 500 is 10. What might account for the difference?
16. Suppose you are chief financial officer of a private toy company. The chief executive officer has asked you to come up with an estimate for the company’s price per share. Your company’s earnings per share were $2.00 in the year just ended. You know that you should look at public company comparables; however, they seem to fall into two camps: those with P/E ratios of 8x earnings and those with P/E ratios of 14x earnings. You are perplexed at the difference until you notice that on average, the lower P/E companies have higher leverage than the higher P/E group. The 8x P/E group has a debt/equity ratio of 2:1. The 14x P/E group has a debt/equity ratio of 1:1. If your toy company has a debt/equity ratio of 1.5:1, what might you tell the CEO about your company’s equity value per share?
20. The price of Fuddy Co. stock recently jumped when the sudden unexpected death of its CEO was announced. What might account for such a market reaction?
21. Suppose we study the returns earned by corporate officers trading on the basis of inside information, that is, information which is known to corporate insiders but not publicly available. If these types of trades produce above average returns what does this tell us about market efficiency?
Chapter 9
3. Under the constant-growth-rate discounted dividend model assume we hold the
expected dividend one period ahead constant. What will happen to the price per share
of a stock that sees both its growth rate and the market capitalization rate rise by the
same proportion, for example, a 25% increase in both variables?
4. The constant-growth-rate discounted dividend model formula is given by:
This can be rewritten as: (CHECK TEXTBOOK END OF CHAPTER 9 QUESTIONS)
How would you interpret this equation? (CHECK TEXTBOOK END OF CHAPTER 9 QUESTIONS)
5. The Rusty Clipper Fishing Corporation is expected to pay a cash dividend of $5 per
share this year. You estimate that the market capitalization rate for this stock should be
10% per year. If its current price is $25 per share, what can you infer about its
expected growth rate of dividends?
6. The DDM Corporation has just paid a cash dividend (D0) of $2 per share. It has
consistently increased its cash dividends in the past by 5% per year, and you expect it
to continue to do so. You estimate that the market capitalization rate for this stock
should be 13% per year.
a. What is your estimate of the intrinsic value of a share (derived using the DDM
model)?
b. Suppose that the actual price of a share is $20. By how much would you have to
adjust each of the following model parameters to “justify” this observed price:
(i) the growth rate of dividends and (ii) the market capitalization rate.
10. Challenge Problem: The 2Stage Co. just paid a dividend of $1 per share. The
dividend is expected to grow at a rate of 25% per year for the next 3 years and then to
level off to 5% per year forever. You think the appropriate market capitalization rate is
20% per year.
a. What is your estimate of the intrinsic value of a share of the stock?
b. If the market price of a share is equal to this intrinsic value, what is the expected
dividend yield?
c. What do you expect its price to be one year from now? Is the implied capital gain
consistent with your estimate of the dividend yield and the market capitalization rate?
Chapter 10
1. Suppose you are aware of the following investment opportunity: You could open a
coffee shop around the corner from your home for $25,000. If business is strong, you
could net $15,000 in after-tax cash flows each year over the next 5 years.
a. If you knew for certain the business would be a success, would this be a risky
investment?
b. Now assume this is a risky venture and that there is a 50% chance it is a success
and a 50% chance you go bankrupt within 2 years. You decide to go ahead and
invest. If the business subsequently goes bankrupt, did you make the wrong
decision based on the information you had at the time? Why or why not?
6. Which risk management technique has been chosen in each of the following
situations?
- Installing a smoke detector in your home
- Investing savings in T-bills rather than in stocks
- Deciding not to purchase collision insurance on your car
- Purchasing a life insurance policy for yourself
20. Find the expected return and variability of the returns measured as the standard
deviation from the following return distribution: (CHECK TEXTBOOK END OF CHAPTER 10 QUESTIONS)
21. Suppose the following represents the historical returns for Microsoft and Lotus
Development Corporation: (CHECK TEXTBOOK END OF CHAPTER 10 QUESTIONS)
a. What is the mean return for Microsoft? For Lotus?
b. What is the standard deviation of returns for Microsoft? For Lotus?
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