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Practice problems on equity valuation .docx

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Georgia State University * FI 4000 Finance Jul 10, 2023 3
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Practice Problems for Equity valuation

A. IBX Stock Intrinsic-Value
You expect the price of IBX stock to be INR 59.77 per share a year from now. Its current market
price is INR 50, and you expect it to pay a dividend 1 year from now of INR 2.15 per share.

a. What is the stock's expected dividend yield, rate of price appreciation, and holding-period
return?
b. If the stock has a beta of 1.15, the risk-free rate is 6% per year, and the expected rate of
return on the market portfolio is 14% per year, what is the required rate of return on IBX
stock?
c. What is the intrinsic value of IBX stock, and how does it compare to the current market
price?

a. Dividend yield = 2.15 /50 = 4.3%

Capital gains yield = (59.77 - 50) / 50 = 19.54%
Total return = 4.3% + 19.54% = 23.84%

b. k = 6% + 1.15 (14% - 6%) = 15.2%

c. Po = (2.15 + 59.77) / 1.152 = INR 53.75, which exceeds the market price. This would
indicate a "buy" opportunity.

B. i) IBX's stock dividend at the end of this year is expected to be INR 2.15, and it is expected to
grow at 11.2% per year forever. If the required rate of return on IBX stock is 15.2% per year,
what is its intrinsic value?

ii) If IBX's current market price is equal to this intrinsic value, what is next year's expected
price?

iii) If an investor were to buy IBX stock now and sell it after receiving the INR 2.15 dividend
a year from now, what is the expected capital gain (i.e., price appreciation) in percentage
terms? What is the dividend yield, and what would be the holding-period return?

i)D1 / (k - g) = INR 2.15 / (0.152 - 0.112) = INR 53.75

ii)P1 = Po (1 + g) = INR 53.75 (1.112) = INR 59.77
iii)The expected capital gain equals INR 59.77 - INR 53.75 = INR 6.02 for a percentage gain
of 11.2%. The dividend yield is D1 / Po = 2.15 / 53.75 = 4%, for a holding-period return of
4% + 11.2% = 15.2%.

C. ABC stock has an expected ROE of 12% per year, expected earnings per share of INR 2.00,
and expected dividends of INR 1.50 per share. Its market capitalization rate is 10% per year.

a) What is its expected growth rate, its price, and its P/E ratio?
b) If the plowback rate were 0.4, what would be the expected dividend per share, the
growth rate, price, and the P/E ratio?

a) ROE = 12%; b = INR 50 / INR 2.00 = 25

g = ROE x B = 12% x 0.25 = 3%
Po = D1 / (k - g) = INR 1.50 / (0.10 - 0.03) = INR 21.44

Po / E1 = INR 21.44 / INR 2.00 = 10.71

b) If b = 0.4, then 0.4 x INR 2.00 = INR 80.00 would be reinvested and the remainder of
earnings, or INR 1.20, would be paid as dividends.
g = 12% x 0.4 = 4.8%
Po = D1 / (k - g) = INR 1.20 / (0.10 - 0.048) = INR 23.08
Po / E1 = INR 23.08 / INR 2.00 = 11.54

D. CAPM problems and questions

1. If there are only a few investors who perform security analysis, and all others hold the
market portfolio, M, would the CML still be the efficient CAL for investors who do not engage
in security analysis? Why or why not?

We can characterize the entire population by two representative investors. One is the
"uninformed" investor, who does not engage in security analysis and holds the market
portfolio, whereas the second representative investor optimizes using the Markowitz
algorithm with input from security analysis. The uninformed investor does not know what
input the informed investor uses to make portfolio purchases. The uninformed investor
knows, however, that if the other investor is informed, the market portfolio proportions will
be optimal. Therefore, to depart from these prescriptions would be an uninformed bet,
which will, on average, reduce the efficiency of diversification with no compensating
improvement in expected returns.

2. Suppose that the risk premium of the market portfolio is estimated at 10% with a standard
deviation of 28%. What is the risk premium on a portfolio invested 25% in Infosys and 75%
in HUL, if they have betas of 1.45 and 0.74 respectively?

For these investment proportions, Winfosys and Whul, the portfolio beta is:

Beta(p) = [Winfosys x Beta (Infosys)] + [Whul x Beta (HUL)]

= (0.25 x 1.45) + (0.75 x 0.74) = 0.9175

3. Stock XYZ has an expected return of 12% and risk of B = 1. Stock ABC has expected return
of 13% and B = 1.5. The market's expected return is 11%, and Rf = 5%.

a. According to the CAPM, which stock is a better buy?

b. What is the alpha if each stock? Plot the SML and each stock's risk-return point on one
graph. Show the alphas graphically.

The alpha of a stock is its expected return in excess of that required by the CAPM:

Alpha (XYZ) = 12 - [5 + 1.0 (11 - 5)] = 1%

Alpha (ABC) = 13 - [5 + 1.5 (11 - 5)] = - 1%

ABC plots below the SML, while XYZ plots above.

4. The risk-free rate is 8% and the expected return on the market portfolio is 16%. A firm
considers a project that is expected to have a beta of 1.3.

a. What is the required rate of return on the project?

b. If the expected IRR of the project is 19%, should it be accepted?

The project-specific required return is determined by the project beta coupled with the
market risk premium and the risk-free rate. The CAPM tells us that an acceptable expected
rate of return for the project is:

8 + 1.3 (16 - 8) = 18.4%

which becomes the project's hurdle rate. If the IRR of the project is 19%, then it is desirable.
Any project with an IRR equal to or less than 18.4% should be rejected.

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