Exam 4: Security Analysis and Portfolio Theory

Consider the following table of partial cash flows: Assume that the risk-free rate over the period is 10% and price the put option.

Discuss whether the following statement is true or false: The existence of a downward-sloping yield curve is inconsistent with the liquidity preference theory.

In a strongly efficient market,the price of a firm's stock should not change if no new information comes out about the firm.

UV Company has just been formed with $100 million in equity capital to invest in five projects,all with infinite lives,with the following characteristics: project return on equity investment needs A 14\% \ 20 million B 17\% \ 15 million C 11\% \ 25 million D 19\% \ 20 million E 10\% \ 20 million If all five projects have a beta of 1 and the riskless rate is 7%,what is the estimated price-to-book-value ratio of this firm assuming that all five projects are taken? (Assume market rate of return of 15% and the growth rate for the company is 20%)

Firm A has a stock price of $10 per share,an expected dividend for next year of $1 per share,an expected constant growth rate of 8% per year,and a beta of 0.8 on its stock.Firm B has a stock price of $50 per share,an expected dividend for next year of $5.50 per share,a retention rate of 40%,a historical rate of return on investment of 20%,and a beta of 1.3 on its stock.If the riskless rate is 10% and the expected return on the market portfolio is 18%,is either of these stocks underpriced or overpriced? What is your buy/sell recommendation for each stock?

Consider the following data for bonds A and B: price annual cash flows \dagger=0 t=1 t=2 t=3 A \ 990 \ 100 \ 1,100 0 B \ 900 \ 50 \ 50 \ 1,050 a. Assuming a flat yield curve of 10%, the expectations theory of the term structure, and semi-annual compounding, which bond is a superior investment? b. If you kept everything the same in part a, except for replacing the assumption of the expectations theory with the assumption of a liquidity premium theory, would your answer to part a be affected and, if so, how?

Consider a portfolio consisting of long positions in both 6-month Treasury bills and call options.What is the payoff pattern (potential cash flows)and what is this portfolio equivalent to? (Hint: Use put-call parity.)

Discuss whether the following statement is true or false: An investor is considering purchasing either a zero-coupon bond with 5 years to maturity or a 10% coupon bond with 5 years to maturity,but if both bonds have identical yields to maturity and the investor expects to hold the bond for the full 5 years,then it does not matter which bond is purchased.

The duration of a perpetual bond is infinite.

Describe: a. the transactions a grain elevator operator would make in using March corn futures to hedge a silo full of corn from October through February. b. how the price on a futures contract is related to the price for the underlying commodity. c. how futures prices are expected to move over time.

The duration of a bond decreases as the coupon rate on the bond increases.

Assume bond returns are given by a single-index model where the index is the percentage change in 1 plus the interest rate. a. What is the appropriate measure of how bond returns are affected by the index? b. If the above model is used as a return-generating process, what is the corresponding APT model?

You have been given the following information on AD Corporation,and you expect this information to hold for the next five years: ROA = 20%; debt/equity ratio = 0.5; interest rate on debt = 10%; dividend payout ratio = 20%.After five years have passed,you expect AD's growth rate to be 10%.The annualized six-month T-bill rate is 7%,current EPS is $4.00,and the stock's beta is 1.25.Assume a market rate of return of 15%. a. Using the dividend-discount model, estimate the intrinsic value of the stock. b. The company's CFO is considering increasing his payout ratio to 40% for the first five years. Advise him by estimating the value of the stock with the new payout ratio. c. The CFO is also considering increasing the debt/equity ratio to one. Estimate the value of the stock with the new ratio.

You are trying to value Godzilla,Inc.You are provided with the following data for the company: the current earnings per share is $2.50; the expected return on assets is 15%; the current dividend payout ratio is 40%,and this rate is expected to stay constant over the next five years,during which time the firm expects high growth; the firm has a debt-equity ratio of 0.5; the firm pays an interest rate of 10% on its debt; after the fifth year,the firm is expected to grow at a constant rate of 8%,and the return on assets will remain unchanged at 15%; the firm's beta is 0.8; the riskless rate is 7%; the expected return on the market is 15%. a. Value the firm. b. Mr. Poone Bickens is attempting to take over Godzilla, Inc. He claims that the managers are not managing the firm optimally. In particular, he feels that the firm should prune some of its losing assets and should borrow more money, so that the return on assets will be 20% and the debt-equity ratio will be 1.5. He agrees with the constant growth estimate for the stable phase (after the fifth year and on). Assuming Mr. Bickens is right, how much will he be willing to pay for the firm?

All other things equal,which of the following bond price is more sensitive to interest rate changes?

You are responsible for valuing QXR Corporation,given the following data: current EPS = $4.00; current payout ratio = 40%,ROA = 20%; beta = 1.2; debt/equity ratio = 0.75; interest rate on debt = 12%; annualized 6-month T-bill rate = 8%; number of shares outstanding = 100,000.You expect the firm to grow at 8% after the first five years,with the ROA declining to 15%.You also know that QXR has substantial real estate holdings that are currently unutilized and can be sold for $1,000,000.What is your estimate of QXR's intrinsic value? Assume a market rate of return of 15%.

You can form a portfolio from the following assets: T-bill futures,T-bond futures,stock index futures,and IBM stock.Given the following predictions,indicate which of these assets you would hold and whether you'd be long or short in the asset,so that you will profit if your prediction is correct.(You don't have to give numbers.) a. While the total sales of computers will depend on the overall state of the economy and the stock market (about which you have no strong beliefs), you firmly believe that IBM is going to lose market share. b. The yield curve is currently upward sloping. You don't have any idea where interest rates on average are headed, but at the end of this year, you firmly believe that the yield curve will be downward sloping. c. You believe that the stock market is driven by corporate profits and (inversely) by interest rates. You think that corporate profits are due for a big surge next year, but you aren't sure about interest rates. d. You believe that stocks are going to go up next year, unless there is a spectacular short crash like the one that occurred in October 1987. If there is a crash, you believe that there will be a "flight to safety", i.e., that investors will dump stocks and buy government bonds.

A $1,000 par bond has an annual coupon rate of 12% with semi-annual coupon payments and has a 5-year maturity.Assuming a flat yield curve of 10%,what is the bond's duration?

Discuss whether the following statement is true or false: The promised yield on corporate bonds will in general be higher than the expected yield.

Your friend claims that,since the market went up seven days in a row recently,there is no way that the market could follow a random walk.Discuss whether your friend's claim is true or false.