1. An underpriced stock provides an expected return, which is on the capital asset pricing model (CAPM).

the required return based

(a) less than

(b) equal to

(c) greater than

(d) greater than or equal to

2. You wish to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected

to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant growth DDM, the intrinsic value of stock A is

(a) will be higher than the intrinsic value of stock B

(b) will be the same as the intrinsic value of stock B

(c) will be less than the intrinsic value of stock B

(d) more information is necessary to answer this question

3. You are considering acquiring a common share of R&A Shopping Center Corporation that you would like to hold for one year. You expect to receive both $1.25 in dividends and $35 from the sale of the share at the end of the year. The maximum price you would pay for a share today is if you wanted to earn a 12% return.

(a) $31.25

(b) $32.37

(c) $38.47

(d) $41.32

4. C&N Trading Company is expected to have EPS in the upcoming year of $6.00. The expected ROE is 18.0%. An appropriate required return on the stock is 14%. If the ﬁrm has a plow back ratio of 60%, its growth rate of dividends should be

(a) 2.5%

(b) 4.0%

(c) 8.4%

(d) 10.8%

5. Stern Enterprises is expected to have EPS (Earnings per share) in the upcoming year of $6.00. The expected ROE is 18.0%. An appropriate required return on the stock is 14%. If the ﬁrm has a plow back ratio of 70%, its intrinsic value should be

(a) $20.93

(b) $69.77

(c) $128.57

(d) $150.00

6. Smart Investors, Inc., is expected to pay a dividend of $4.20 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The riskless rate of return is 4% and the expected return on the market portfolio is 14%. Investors use the CAPM to compute the growth rate on the stock, and the constant growth DDM to determine the intrinsic value of the stock. The stock is trading in the market today at $84.00. Using the constant growth DDM and the CAPM, the beta of the stock is

(a) 1.4

(b) 0.9

(c) 0.8

(d) 0.5

7. M&B Gold Mining Corporation is expected to pay a dividend of $6 in the upcoming year. Dividends are expected to decline at the rate of 3% per year. The riskless rate of return is 5% and the expected return on the market portfolio is 13%. The stock of M&B Gold Mining Corporation has a beta of −0.50. Using the constant growth DDM, the intrinsic value of the stock is

(a) $50.00

(b) $150.00

(c) $200.00

(d) $400.00

Detailed Questions

Equity Valuation

8. Suppose that the consensus forecast of security analysts of your favorite company is that earnings next year will be E1 = 5.00 per share. Suppose that the company tends to plow back 50% of its earnings and pay the rest as dividends. If the Chief Financial Oﬃcer (CFO) estimates that the company’s growth rate will be 8% from now onwards, answer the following questions.

(a) If your estimate of the company’s required rate of return on its stock is 10%, what is the equilibrium price of the stock?

(b) Suppose you observe that the stock is selling for $50.00 per share, and that this is the best estimate of its equilibrium price. What would you conclude about either (i) your estimate of the stock’s required rate of return; or (ii) the CFO’s estimate of the company’s future growth rate?

(c) Suppose your own 10% estimate of the stock’s required rate of return is shared by the rest of the market. What does the market price of $50.00 per share imply about the market’s estimate of the company’s growth rate?

Arbitrage

9. The stock PolarBear.com trades on both the South Pole Stock Exchange and the North Pole Stock Exchange.

(a) Suppose the price on the North Pole is $18. What does the No-Arbitrage Condition say about the price on the South Pole? (Assume no trading costs.

(b) Suppose the price on the North Pole is $18 and the price on the the South Pole is $17? How can you make an arbitrage proﬁt? (Assume no trading costs.)

(c) Suppose that the price on the North Pole is $18, that buying or selling on the North Pole costs $2, and that buying or selling on the South Pole is free. What does the No-Arbitrage Condition say about the price on the South Pole?

10. Suppose that there are two securities RAIN and SUN. RAIN pays $100 in there is any rain during the next world cup soccer ﬁnal. SUN pays $100 in there is no rain. Suppose that the world cup soccer ﬁnal is 1 year from today (although this is not true), and suppose that RAIN is trading at a price of $23 and SUN is trading at a price of $70.

(a) If you buy 1 share of RAIN and 1 share of SUN, what is your payoﬀ after 1 year, depending on the weather?

(b) What does the No-Arbitrage Condition imply about the price of a 1-year zero-coupon bond? (Assume no trading costs.)

(c) Suppose that a 1-year zero-coupon bond is trading at $90. Show how you would set up a transaction to earn a riskless arbitrage proﬁt. (Assume no trading costs.)

(d) Suppose that trading zero-coupon bonds is costless, but trading RAIN and SUN each cost $2 per $100 face value. Can you still make an arbitrage proﬁt?

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