Sukhwinder Kleir

Chapter 17
Problem 8 Here are four industries and four forecasts for the macroeconomy. Match the industry to the scenario in which it is likely to be the best performer. Industry Housing construction Health care Gold mining Steel production Economic Forecast Superheated economy: rapidly rising GDP, increasing inflation and interest rates Deep reception: falling inflation, interest rates, and GDP Stagflation: falling GDP, high inflation Healthy expansion: rising GDP, mild inflation, low unemployment

Problem 11 Choose an industry and identify the factors that will determine its performance in the next 3 years. What is your forecast for performance in that time period? Automobile Industry – the factors that will determine its performance in the next 3 years are: - GDP, oil price, unemployment, inflation. Not all industries are equally sensitive to the business cycle. Auto industry is highly volatile to the state of the macroeconomy. 1982 was a year of deep recession and worst year for automobile industry. As US economy is facing a recession and is not good time for automobile industry. For the short term this industry is definitely facing further hardships, in the longer term as the economy will recover automobile industry will see an upturn.

Problem 12 Why do you think the index of consumer expectations is a useful leading indicator of the macroeconomy? (see Table 17.2) Consumer credit increased at an annual rate of 5-1/2 percent in the first quarter of 2008. In that quarter, revolving credit increased at an annual rate of 6-3/4 percent, and nonrevolving credit increased at an annual rate of 4-1/2 percent. In March, consumer credit increased at an annual rate of 7-1/4 percent. (Data from Fed Reserve Website)

the government has a variety of options. will pay a year-end dividend of $2 per share. The CCI index is a useful indicator of macroeconomy. retailers. Likewise. banks can anticipate a decrease in lending activity. moves of 5% or more often indicate a change in the direction of the economy. a large computer company. Manufacturers may pare down inventories to reduce overhead and/or delay investing in new projects and facilities.Sukhwinder Kleir Consumer Confidence Index (CCI) is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending. possibly indicating that the economy is in trouble. When faced with a down-trending index. the more likely they are to make purchases. consumers spend money. when consumers confidence is trending up. MBI. mortgage applications and credit card use. Manufacturers can increase production and hiring. While index changes of less than 5% are often dismissed as inconsequential.12 = 12 % 0. Low consumer confidence is a sign of low confidence in income stability. A month-on-month decreasing trend suggests consumers have a negative outlook on their ability to secure and retain good jobs. If the stock is selling at $50 per share. indicating higher consumption. a rising trend in consumer confidence indicates improvements in consumer buying patterns. Conversely. Manufacturers. what must be the market’s expectation of the growth rate of MBI dividends? P0 = $50 = D1 k −g $2 $2 ⇒ g = 0. particularly large-ticket items that require financing. Banks can expect increased demand for credit. Builders can prepare for a rise in home construction and government can anticipate improved tax revenues based on the increase in consumer spending. Chapter 18 Problem 3 a) Computer stocks currently provide an expected rate of return of 16%. consumers are saving more than they are spending. The idea is that the more confident people feel about the stability of their incomes. such as issuing a tax rebate or taking other fiscal or monetary action to stimulate the economy.16 − g . manufacturers may expect consumers to avoid retail purchases. When confidence is trending down. banks and the government monitor changes in the CCI in order to factor in the data in their decision-making processes. Thus.16 − $50 = 0.

Sundanci's FCFE per share equals dividends per share. depreciation. a) Calculate the amount of FCFE per share for the year 2000. however.05 The price falls in response to the more pessimistic forecast of dividend growth. The FCFE is a measure of how much the firm can afford to pay out as dividends.18 k − g 0. Capital expenditures. Naylor believes that Sundaci’s FCFE will grow at 27% for 2 years and 13% thereafter. CFA. using the data from table 18a. . has been directed to determine the value of Sundaci’s stock using the Free Cash Flow to Equity (FCFE) model. Sundanci's FCFE for the year 2000 is computed as follows: FCFE = Earnings after tax + Depreciation expense − Capital expenditures − Increase in NWC = $80 million + $23 million − $38 million − $41 million = $24 million FCFE per share = FCFE/number of shares outstanding = $24 million/84 million shares = $0.286 At the given dividend payout ratio. the P/E ratio decreases.16 − 0. what will happen to the price of MBI stock? What (qualitatively) will happen to the company’s price-earnings ratio? P0 = D1 $2 = = $18 . The lower P/E ratio is evidence of the diminished optimism concerning the firm's growth prospects. Therefore. and working capital are all expected to increase proportionately with FCFE. Free cash flow to equity (FCFE) is defined as the cash flow remaining after meeting all financial obligations (including debt payment) and after covering capital expenditure and working capital needs.Sukhwinder Kleir b) If dividend growth forecasts for MBI are revised downward to 5% per year. is unchanged. Problem 10a Abbey Naylor. The forecast for current earnings. but in a given year may be more or less than the amount actually paid out.

. what rate of return do Nogro’s investors require? D1 = 0. the stock price would be unaffected if Nogro were to cut its dividend payout ratio to 25%. Earnings per share in the coming year are expected to be $2.10 Therefore: k= D1 $1 +g = + 0. The additional earnings that would be reinvested would earn the ROE (20%). a) Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely. what would happen to its stock price? What if Negro eliminated the dividend? Since k = ROE.0% P0 $10 b) By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested? Since k = ROE. the NPV of future investment opportunities is zero: PVGO = P0 − E0 = $10 − $10 = $0 k c) If Nogro were to cut its dividend payout ratio to 25%.5 × $2 = $1 g = b × ROE = 0.5 × 0.20 = 0.Sukhwinder Kleir Problem 15 The stock of Nogro Corporation is currently selling for $10 per share.20 = 20. if Nogro eliminated the dividend. Again. this would have no impact on Nogro’s stock price since the NPV of the additional investments would be zero. The company has a policy of paying out 50% of its earnings each year in dividends.10 = 0.

Put option. e. has a client who believes the common stock price of TRT Materials (currently $58 per share) could move substantially in either direction in reaction to an expected court decision involving the company.Sukhwinder Kleir Chapter 20 Problem 1 Turn back to figure 20. X = $85.75 1. X = 90 Put option.00 0. A strangle is a portfolio of a put and a call with different exercise prices but the same expiration date. X=80 Put option.80 Problem 10a Donna Donie.25 -1. X = $80.60 -0. X = $80.35 2. f. X = $90. X = 80 Call option. Call option. Call option.00 Profit 0. but asks Donie for advice about implementing a strangle strategy to capitalize on the possible stock price movement. d.00 0.90 0. Call option. Call option. Put option. The client currently owns no TRT shares.80 Payoff 5.40 0. which lists prices of various IBM options. assuming that the stock price on the maturity date is $85.25 6.90 -0. Use the data in the figure to calculate the payoff and the profits for investments in each of the following May maturity options.35 -2. X = 90 Cost 4. b. X = 85 Call option. Donie gathers the TRT optionpricing data: . a.00 0. Put option.00 0.1.00 5. X = $90. X = 85 Put option. CFA. c.75 -1. X = $85.

00 below the put exercise price.125 Common Equity $35 per share $0 $45 per share a. Recommend whether Donie should choose a long strangle strategy or a short strangle strategy to achieve the client’s objective. In a strangle strategy. is evaluating his investment alternatives in Ytel Incorporated by analyzing a Ytel convertible bond and Ytel common equity. and will experience a profit if the stock price moves more than $9. A long strangle option strategy consists of buying a put and a call with the same expiration date and the same underlying asset.00 above the call exercise price or more than $9.20 . the: i. Current market conversion price for the Ytel convertible bond. either up or down. the call has an exercise price above the stock price and the put has an exercise price below the stock price. Donie should choose the long strangle strategy. An investor who buys (goes long) a strangle expects that the price of the underlying asset (TRT Materials in this case) will either move substantially below the exercise price on the put or above the exercise price on the call.000 4% $980 $925 25 At any time $1. Characteristics of the two securities are given in the following exhibit: Characteristics Par value Coupon (annual payment) Current market price Straight bond value Conversion ratio Conversion option Dividend Expected market price in 1 year Convertible Bond $1. the long strangle investor buys both the put option and the call option for a total cost of $9. Calculate. This strategy would enable Donie's client to profit from a large move in the stock price. based on the exhibit. The current market conversion price is computed as follows: Market conversion price = market price of the convertible bond/conversion ratio = $980/25 = $39. but different exercise prices. Problem 27a Rich McDonald.00. in reaction to the expected court decision. CFA.Sukhwinder Kleir Characteristic Price Strike price Time to expiration Call Option $5 $ 60 90 days from now Put Option $4 $ 55 90 days from now a. With respect to TRT.

1888 = 18.88% iii.57% . The expected one-year return for the Ytel common equity is: Expected return = [(end of year price + dividend)/current price] – 1 = ($45/$35) – 1 = 0.125 + $40)/$980] – 1 = 0. Expected 1-year rate of return for Ytel convertible bond. The expected one-year return for the Ytel convertible bond is: Expected return = [(end of year price + coupon)/current price] – 1 = [($1.Sukhwinder Kleir ii.2857 = 28. Expected 1-year rate of return for Ytel common equity.

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