PGP-INVESTMENTS, TERM 3- BADRINATH

SUGGESTED END-OF-CHAPTER PROBLEMS.

SOLUTIONS TO NUMERICAL PROBLEMS APPEAR BELOW.
CHAPTER 2 (3-6, 11-12)
11. a. At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80
At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333
The rate of return is: (83.333/80) 1 = 4.17%

b. In the absence of a split, Stock C would sell for 110, so the value of the index
would be: 250/3 = 83.333 with a divisor of 3.
After the split, stock C sells for 55. Therefore, we need to find the divisor (d)
such that: 83.333 = (95 + 45 + 55)/d d = 2.340. The divisor fell, which is
always the case after one of the firms in an index splits its shares.

c. The return is zero. The index remains unchanged because the return for each
stock separately equals zero.

12. a. Total market value at t = 0 is: ($9,000 + $10,000 + $20,000) = $39,000

Total market value at t = 1 is: ($9,500 + $9,000 + $22,000) = $40,500
Rate of return = ($40,500/$39,000) 1 = 3.85%

b. The return on each stock is as follows:

rA = (95/90) 1 = 0.0556
rB = (45/50) 1 = 0.10
rC = (110/100) 1 = 0.10
The equally weighted average is:
[0.0556 + (-0.10) + 0.10]/3 = 0.0185 = 1.85%

CHAPTER 3 (1-5, 6-12, 15, 16)

6. a. The stock is purchased for: 300 $40 = $12,000
The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of
$8,000.

b. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of
the year, the amount of the loan owed to the broker grows to:
$4,000 1.08 = $4,320
 Therefore, the remaining margin in the investors account is:
$9,000 $4,320 = $4,680
The percentage margin is now: $4,680/$9,000 = 0.52, or 52%
Therefore, the investor will not receive a margin call.

c. The rate of return on the investment over the year is:

(Ending equity in the account Initial equity)/Initial equity
= ($4,680 $8,000)/$8,000 = 0.415, or 41.5%

Alternatively, divide the initial equity investments into the change in value plus the
interest payment:
($3,000 loss + $320 interest)/$8,000 = -0.415.

7. a. The initial margin was: 0.50 1,000 $40 = $20,000

As a result of the increase in the stock price Old Economy Traders loses:
$10 1,000 = $10,000
Therefore, margin decreases by $10,000. Moreover, Old Economy Traders must pay
the dividend of $2 per share to the lender of the shares, so that the margin in the
account decreases by an additional $2,000. Therefore, the remaining margin is:
$20,000 $10,000 $2,000 = $8,000

b. The percentage margin is: $8,000/$50,000 = 0.16, or 16%

So there will be a margin call.

c. The equity in the account decreased from $20,000 to $8,000 in one year, for a rate of
return of: ($12,000/$20,000) = 0.60, or 60%

8. a. The buy order will be filled at the best limit-sell order price: $50.25

b. The next market buy order will be filled at the next-best limit-sell order
price: $51.50

c. You would want to increase your inventory. There is considerable buying demand at
prices just below $50, indicating that downside risk is limited. In contrast, limit sell
orders are sparse, indicating that a moderate buy order could result in a substantial price
increase.
9. a. You buy 200 shares of Telecom for $10,000. These shares increase in value by 10%, or
$1,000. You pay interest of: 0.08 $5,000 = $400
$1, 000 $400
0.12 12%
$5, 000
The rate of return will be:
b. The value of the 200 shares is 200P. Equity is (200P $5,000). You will receive a
margin call when:
200 P $5,000
200 P
= 0.30 when P= $35.71 or lower

10. a. Initial margin is 50% of $5,000, or $2,500.

b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for
margin). Liabilities are 100P. Therefore, equity is ($7,500 100P). A margin call will
be issued when:
$7,500 100 P
100 P
= 0.30 when P = $57.69 or higher

11. The total cost of the purchase is: $20 1,000 = $20,000
You borrow $5,000 from your broker and invest $15,000 of your own funds. Your
margin account starts out with equity of $15,000.
a. (i) Equity increases to: ($22 1,000) $5,000 = $17,000
Percentage gain = $2,000/$15,000 = 0.1333, or 13.33%
(ii) With price unchanged, equity is unchanged.
Percentage gain = zero
(iii) Equity falls to ($18 1,000) $5,000 = $13,000
Percentage gain = ($2,000/$15,000) = 0.1333, or 13.33%
The relationship between the percentage return and the percentage change in the price
of the stock is given by:
Total investment
Investor' s initial equity
% return = % change in price = % change in price 1.333
For example, when the stock price rises from $20 to $22, the percentage change in price
is 10%, while the percentage gain for the investor is:
 $20,000
$15,000
% return = 10% = 13.33%

b. The value of the 1,000 shares is 1,000P. Equity is (1,000P $5,000). You will
receive a margin call when:
1,000 P $5,000
1,000 P
= 0.25 when P = $6.67 or lower

c. The value of the 1,000 shares is 1,000P. But now you have borrowed $10,000 instead
of $5,000. Therefore, equity is (1,000P $10,000). You will receive a margin call
when:
1,000 P $10,000
1,000 P
= 0.25 when P = $13.33 or lower
With less equity in the account, you are far more vulnerable to a margin call.

d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000 1.08 = $5,400
The equity in your account is (1,000P $5,400). Initial equity was $15,000.
Therefore, your rate of return after one year is as follows:
(1,000 $22) $5,400 $15,000
$15,000
(i) = 0.1067, or 10.67%
(1,000 $20) $5,400 $15,000
$15,000
(ii) = 0.0267, or 2.67%
(1,000 $18) $5,400 $15,000
$15,000
(iii) = 0.1600, or 16.00%
The relationship between the percentage return and the percentage change in the price
of Intel is given by:
Total investment Funds borrowed
% change in price 8%
Investor' s initial equity Investor' s initial equity
% return =
For example, when the stock price rises from $40 to $44, the percentage change in
price is 10%, while the percentage gain for the investor is:
 $20,000 $5,000
10% 8%
$15,000 $15,000
=10.67%

e. The value of the 1000 shares is 1,000P. Equity is (1,000P $5,400). You will receive
a margin call when:
1,000 P $5,400
1,000 P
= 0.25 when P = $7.20 or lower

12. a. The gain or loss on the short position is: (1,000 P)

Invested funds = $15,000
Therefore: rate of return = (1,000 P)/15,000
The rate of return in each of the three scenarios is:
(i) Rate of return = (1,000 $2)/$15,000 = 0.1333, or13.33%
(ii) Rate of return = (1,000 $0)/$15,000 = 0%
(iii) Rate of return = [1,000 ($2)]/$15,000 = +0.1333, or+13.33%

b. Total assets in the margin account equal:

$20,000 (from the sale of the stock) + $15,000 (the initial margin) = $35,000
Liabilities are 500P. You will receive a margin call when:
$35,000 1,000 P
1,000 P
= 0.25 when P = $28 or higher

c. With a $1 dividend, the short position must now pay on the borrowed shares: ($1/share
1000 shares) = $1000. Rate of return is now:
[(1,000 P) 1,000]/15,000
(i) Rate of return = [(1,000 $2) $1,000]/$15,000 = 0.2000, or 20.00%
(ii) Rate of return = [(1,000 $0) $1,000]/$15,000 = 0.0667, or 6.67%
(iii) Rate of return = [(1,000) ($2) $1,000]/$15,000 = +0.067, or +6.67%
Total assets are $35,000, and liabilities are (1,000P + 1,000). A margin call will be
issued when:
35,000 1,000 P 1,000
1,000 P
= 0.25 when P = $27.2 or higher.
CHAPTER 5 (Problems 1-6)

CHAPTER 17 (Problems 1-13)

CHAPTER 18. (Problems 5-13, CFA 1-3).

$1.22 (1.05)
k 0.05 .09, or 9%
$32.03
5.
6.
$1.05
$35
(k 0.05)
$1.05
k 0.05 0.08 8%
$35

$3.64
PVGO $41 $0.56
0.09
7.

D1 $2
P0 $18.18
k g 0.16 0.05
8. a.
8.b The price falls in response to the more pessimistic dividend forecast. The forecast for
current year earnings, however, is unchanged. Therefore, t*he P/E ratio falls. The lower P/E
ratio is evidence of the diminished optimism concerning the firm's growth prospects.

9. a. g = ROE b = 16% 0.5 = 8%

D1 = $2 (1 b) = $2 (1 0.5) = $1
D1 $1
P0 $25.00
k g 0.12 0.08

b. P3 = P0(1 + g)3 = $25(1.08)3 = $31.49

k rf [ E (rm ) rf ] 6% 1.25 (14% 6%) 16%
2
g 9% 6%
3
1
D1 E0 (1 g ) (1 b) $3 (1.06) $1.06
3
D1 $1.06
P0 $10.60
k g 0.16 0.06
10. a.

b. Leading P0/E1 = $10.60/$3.18 = 3.33

Trailing P0/E0 = $10.60/$3.00 = 3.53

E1 $3.18
PVGO P0 $10.60 $9.275
k 0.16
c.
The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than
the market capitalization rate (16%).

d. Now, you revise b to 1/3, g to 1/3 9% = 3%, and D1 to:

E0 (1 + g) (2/3)
$3 1.03 (2/3) = $2.06
Thus:
V0 = $2.06/(0.16 0.03) = $15.85
V0 increases because the firm pays out more earnings instead of reinvesting a poor
ROE. This information is not yet known to the rest of the market.

D1 $8
P0 $160
k g 0.10 0.05
11. a.

b. The dividend payout ratio is 8/12 = 2/3, so the plowback ratio is b = 1/3. The implied
value of ROE on future investments is found by solving:
g = b ROE with g = 5% and b = 1/3 ROE = 15%
 c. Assuming ROE = k, price is equal to:
E1 $12
P0 $120
k 0.10

Therefore, the market is paying $40 per share ($160 $120) for growth opportunities.

12. a. k = D1/P0 + g
D1 = 0.5 $2 = $1
g = b ROE = 0.5 0.20 = 0.10
Therefore: k = ($1/$10) + 0.10 = 0.20, or 20%

b. Since k = ROE, the NPV of future investment opportunities is zero:

E1
PVGO P0 $10 $10 0
k
c. Since k = ROE, the stock price would be unaffected by cutting the dividend and
investing the additional earnings.

13. a. k = rf + [E(rM ) rf ] = 8% + 1.2(15% 8%) = 16.4%

g = b ROE = 0.6 20% = 12%
D0 (1 g ) $4 1.12
V0 $101.82
kg 0.164 0.12

b. P1 = V1 = V0(1 + g) = $101.82 1.12 = $114.04

D1 P1 P0 $4.48 $114.04 $100
E (r ) 0.1852, or 18.52%
P0 $100

CFA PROBLEMS

1. a. This director is confused. In the context of the constant growth model

[i.e., P0 = D1/ k g)], it is true that price is higher when dividends are higher holding
everything else including dividend growth constant. But everything else will not be
constant. If the firm increases the dividend payout rate, the growth rate g will fall, and
stock price will not necessarily rise. In fact, if ROE > k, price will fall.
 b. (i) An increase in dividend payout will reduce the sustainable growth rate as less
funds are reinvested in the firm. The sustainable growth rate
(i.e. ROE plowback) will fall as plowback ratio falls.
(ii) The increased dividend payout rate will reduce the growth rate of book value for
the same reason -- less funds are reinvested in the firm.

2. Using a two-stage dividend discount model, the current value of a share of Sundanci is
calculated as follows.
D3
D1 D2 (k g )
V0
(1 k ) (1 k )
1 2
(1 k ) 2

$0.5623
$0.3770 $0.4976 (0.14 0.13)
$43.98
1.141 1.14 2 1.14 2

where:
E0 = $0.952
D0 = $0.286
E1 = E0 (1.32)1 = $0.952 1.32 = $1.2566
D1 = E1 0.30 = $1.2566 0.30 = $0.3770
E2 = E0 (1.32)2 = $0.952 (1.32)2 = $1.6588
D2 = E2 0.30 = $1.6588 0.30 = $0.4976
E3 = E0 (1.32)2 1.13 = $0.952 (1.32)2 1.13 = $1.8744
D3 = E3 0.30 = $1.8743 0.30 = $0.5623

3. a. 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. The FCFE is a measure of how much the firm
can afford to pay out as dividends but, in a given year, may be more or less than the
amount actually paid out.
Sundanci's FCFE for the year 2008 is computed as follows:
FCFE = Earnings + Depreciation Capital expenditures Increase in NWC
= $80 million + $23 million $38 million $41 million = $24 million
FCFE $24 million
$0.286
# of shares outstanding 84 million shares
FCFE per share =
 At this payout ratio, Sundanci's FCFE per share equals dividends per share.

b. The FCFE model requires forecasts of FCFE for the high growth years (2012 and
2013) plus a forecast for the first year of stable growth (2014) in order to allow for an
estimate of the terminal value in 2013 based on perpetual growth. Because all of the
components of FCFE are expected to grow at the same rate, the values can be
obtained by projecting the FCFE at the common rate. (Alternatively, the components
of FCFE can be projected and aggregated for each year.)
This table shows the process for estimating the current per share value:

FCFE Base Assumptions

Shares outstanding: 84 million, k = 14%
Actual Projected Projected Projected
2011 2012 2013 2014
Growth rate (g) 27% 27% 13%
Total Per Share
Earnings after tax $80 $0.952 $1.2090 $1.5355 $1.7351
Plus: Depreciation expense 23 0.274 0.3480 0.4419 $0.4994
Less: Capital expenditures 38 0.452 0.5740 0.7290 $0.8238
Less: Increase in net working capital 41 0.488 0.6198 0.7871 $0.8894
Equals: FCFE 24 0.286 0.3632 0.4613 $0.5213
Terminal value $52.1300*
Total cash flows to equity $0.3632 $52.5913
Discounted value $0.3186 $40.4673
Current value per share $40.7859
*Projected 2013 terminal value = (Projected 2014 FCFE)/(r g)
Projected 2013 Total cash flows to equity =
Projected 2013 FCFE + Projected 2013 terminal value
Discounted values obtained using k= 14%
Current value per share=Sum of discounted projected 2012 and 2013 total FCFE

c. i. The DDM uses a strict definition of cash flows to equity, i.e. the expected dividends
on the common stock. In fact, taken to its extreme, the DDM cannot be used to estimate
the value of a stock that pays no dividends. The FCFE model expands the definition of
cash flows to include the balance of residual cash flows after all financial obligations and
investment needs have been met. Thus the FCFE model explicitly recognizes the firms
investment and financing policies as well as its dividend policy. In instances of a change
of corporate control, and therefore the possibility of changing dividend policy, the FCFE
model provides a better estimate of value. The DDM is biased toward finding low P/E
ratio stocks with high dividend yields to be undervalued and conversely, high P/E ratio
stocks with low dividend yields to be overvalued. It is considered a conservative model in
that it tends to identify fewer undervalued firms as market prices rise relative to
fundamentals. The DDM does not allow for the potential tax disadvantage of high
dividends relative to the capital gains achievable from retention of earnings.

ii. Both two-stage valuation models allow for two distinct phases of growth, an initial
finite period where the growth rate is abnormal, followed by a stable growth period that is
expected to last indefinitely. These two-stage models share the same limitations with
respect to the growth assumptions. First, there is the difficulty of defining the duration of
the extraordinary growth period. For example, a longer period of high growth will lead to
a higher valuation, and there is the temptation to assume an unrealistically long period of
extraordinary growth. Second, the assumption of a sudden shift from high growth to
lower, stable growth is unrealistic. The transformation is more likely to occur gradually,
over a period of time. Given that the assumed total horizon does not shift (i.e., is infinite),
the timing of the shift from high to stable growth is a critical determinant of the valuation
estimate. Third, because the value is quite sensitive to the steady-state growth assumption,
over- or underestimating this rate can lead to large errors in value. The two models share
other limitations as well, notably difficulties in accurately forecasting required rates of
return, in dealing with the distortions that result from substantial and/or volatile debt
ratios, and in accurately valuing assets that do not generate any cash flows.