WEEK TEN
REVIEW QUESTIONS AND PROBLEMS
Company Analysis
Do the following textbook questions and problems to review your readings. Then check
your answers below.
Chapter 17, pages 541 to542: Questions 2, 10, 13, 15 and 18.
Chapter 17, pages 543 to 544: Problem 1.
ANSWERS TO REVIEW QUESTIONS
CHAPTER 17
2.
A stock's intrinsic value can be estimated by using the dividend discount model or
the earnings multiplier model.
10. Although higher ROE leads to higher EPS, two factors determine stock price, the
ultimate variable of interest to investors. The increasing use of debt financing
increases the risk to stockholders, raising their required rate of return. The
increase in the required rate of return will, at some point, offset the higher EPS and
lower the stock price.
13. Malkiel and Cragg, among others, have shown how important it is to know what the
market thinks the earnings growth rate will be. Investors form expectations about
EPS, and these expectations play a key role in affecting stock prices. In short,
earnings expectations are a key variable in selecting stocks.
15. Beta reflects the relative systematic risk for a stock. Other things being equal, the
higher the beta, the higher the risk and the higher the required rate of return.
Investors will want to know about a stock's beta in order to estimate the volatility of
the stock's returns. If a rise in the market is expected, investors would prefer,
other things being equal, stocks with higher betas. Likewise, with an expected
market decline, lower betas would be preferred if stocks are to be held.
18. As Equation 17-8 shows, the three variables that affect the P/E ratio are:
(1)
The dividend payout ratio (direct relation).
(2)
The required rate of return (inverse relation).
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(3)
The expected growth rate in dividends (direct relation).
ANSWERS TO PROBLEM
CHAPTER 17
1.
For 20X5, the calculations for parts (a), (b) and (c) are:
(a)
(b)
(c)
100(721/8256) = 8.73%
100(289/8256) = 3.50%
289/51.92 = $5.57
The same values for 20X1-20X4 are:
Year
(a)
(b)
(c)
20X1
20X2
20X3
20X4
9.6%
9.0
8.6
8.3
4.2% $4.65
4.3
5.12
3.9
5.16
2.6
4.47
(d), (e), (f), (g), and (h) are calculated for 20X5 and are summarized for 20X1-20X5
below.
(d)
(e)
(f)
(g)
(h)
2315/1342 = 1.72
(736/1872)(100) = 39.3%, as a percentage
1872/51.92 = $36.06
100 (Net Income after tax/Common Equity) = 100(289/1872) =15.4%
(289/4310)100 = 6.7%
Year
(d)
(e)
(f)
(g)
(h)
20X1
20X2
20X3
20X4
2.05
1.86
2.17
1.86
19 %
17.2%
24.3%
45%
$26.46
29.62
32.57
32.88
17.6%
17.3
15.8
13.6
9.0%
8.6
8.2
5.7
Again the 20X5 calculations will be shown for (i) through (n), and summarized for
the other years.
(i)
(j)
(k)
(l)
(m)
4310/1872 = 2.30
**NOTE: 2.30 X 6.7% = 15.4%, the ROE
(289/8256)100 = 3.5%, as a percentage
8256/4310 = 1.92
535 + 139 = $674 mn.
(289/674)100 = 42.9%
2
(n)
(674/8256)100 = 8.2%
Year
20X1
20X2
20X3
20X4
(o)
1.94
2.01
1.93
2.37
(i)
(j)
(k)
(l)
4.2%
4.3
3.9
2.6
2.13
2.00
2.13
2.16
$483mn
509
523
570
(m)
48.0%
50.3
48.8
38.8
(n)
8.8%
8.5
7.9
6.8
Examining the figures for the years 20X1-20X5 from parts (a) through (n), we
see that ROE declined through 20X4, although it recovered somewhat in
20X5. The same is true of ROA. Leverage has increased. Operating
efficiency declined through 20X4 before turning up in 20X5.
Reviewing more basic components, we see that operating income/net
revenue has been deteriorating, as has net profits/revenue. The current ratio
has deteriorated.
In summary, it would appear that GF underwent some deterioration between
20X1 and 20X5 with some (but not complete), improvement in 20X5.
Examining the ROE and ROA in 20X5, we can see that GF had recovered
some ground, but still compared unfavourably to 20X1 and 20X2.
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