Sample problems Fin 327-Fall 2009 2nd mid-term
1. Quadratics Inc is an applications firm that specializes in multimedia software.
Quadratics current earnings are $3.00 per share and expected to grow at 10% each
year. Quadratics typically pays out 40% of its earnings as dividends, but is restricted
from doing so because of a clause in its bond indenture. This clause states that for the
next three years (until the bond matures), Quadratics can only make a dividend
payment of $1.00 per share each year. Analysts estimate the required return on
Quadratics stock to be 15%.
(20 points)
(a) Estimate the expected intrinsic value of Quadratics’ stock when the bond matures.
Price (3) = 0.4 * 3.00 (1.10)4/(0.15 – 0.10) = 35.14
(b) Use a 2-stage dividend model to estimate the intrinsic value for Quadratics now.
Intrinsic value = 1/(1.15) + 1/(1.15)2 + (1+35.14) / (1.15)3 = 25.39
(c) Quadratics trades at a P/E ratio of 11. Based upon your answer in part(b), is
Quadratics a good investment?
A P/E of 11 implies that the stock trades at 11 times earnings, or $ 33.00. Its
intrinsic value is $ 25.39, so it is not a good investment.
(d) J. Hochberg, a rising young financial analyst at PruBache argues that the market is
pricing Quadratics properly and that a constant dividend growth model is appropriate.
In other words, the temporary impact of low dividends (for 3 years) should be
ignored. What is the market’s required rate of return if Mr. Hochberg was accurate?
Do you think he is accurate?
If the market is pricing properly, then the “true” value is really $33. The required rate
of return = D1/P0 + g = 1.32/33 + 0.10 = 14%. In other words, if investors are satisfied
with a lower rate of return, then they should be willing to pay $33 for the stock.
The statement must be interpreted with caution. If you are an investor with a two-year
window, then you will only receive the $1 dividend under the current scheme.
Therefore, ignoring the impact of the dividends will affect your total return.
2. Provide an assessment of the evidence pertaining to semi-strong form market
efficiency, citing at least two situations to make your case.
(10 points)
See textbook/notes
3. A recent article in the Wall Street Journal stated that every year for the last several,
Coca Cola Co. has reported earnings per share that imply a growth rate of 17%. (This
is a true story.). In general, what can companies do towards managing their reported
earnings growth in the above manner? Do you think this practice is pervasive and
why?
(10 points)
Several corporations frequently attempt to smooth their earnings in order to document
steady growth. Among the ways this is done are:
Postpone revenue recognition until long after sale (software)
Adjust rate of return on pension fund contributions
Match unusual gains from asset sales with restructuring charges
Gains/losses from currency translation
The activity appears to be pervasive especially in larger corporations and is often
justified as a process of evolution in accounting practices, especially for newer
industries. Recent notifications by the FASB are geared towards promoting
transparency in earnings reports. It is not clear how much such practices obscure the
transfer of financial information. Investors ought to be able to figure this out.
4. Describe what is meant by market efficiency in the weak form. What does it imply
about the role of “technical” analysis?
(5 points)
Weak form efficiency implies that market prices reflect past price/volume
information. Technical analysts typically design trading strategies based on
exhaustive examinations of charts, graphs and other indicators. If the information that
technical analysis can glean from such strategies is already incorporated in prices (i.e
markets are weak form efficient), then these strategies should not result in systematic
abnormal profits.
5. Compare the role of business cycle investing with market timing. Are they similar or
different? Is one more likely to generate abnormal profits than the other? Be specific
in your answer.
(5 points)
Business cycle investing is similar to market timing in that they both attempt to take
advantage of trends. For instance, if the business cycle is near its peak, interest rates
will generally be high and a decline in rates can be expected. Therefore, investing in
long-maturity and/or low-coupon bonds is the recommended strategy for business
cycle investors. Identifying exactly when the cycle peaks is analogous to market
timing activity. However, timing the business cycle is equivalent to identifying broad
macro-level trends, whereas market timing can also apply to trends in individual
stocks as well and motivates trading in the very short-term based upon firm-specific
news. In general, abnormal profits are not systematically likely.