978-0134083308 Chapter 6 Solution Manual Part 2

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Chapter 6 Common Stocks 101

 Suggested Answers to Discussion Questions

6.1 a. Averaging the returns decade by decade since 1930, one gets 11.1% and the average

annual return from 1900 to 2014 was 11.4%. Like most averages, these returns include over

performing periods like the 1980’s and 90’s and underperforming periods like 2000-2009 which

b. As recent history shows periods of 5 and even 10 years of negative returns are possible but quite

unusual. Severe, prolonged declines typically follow some major economic crisis such as the

Great Depression of the 1930s or the global financial crisis of 2007–2008. Historically, markets

have eventually recovered from these crises and gone on to reach new highs. Ten to twelve

6.2 a. May 15, 2015

d. 21.27

f. 45.50, 19.34

h. +.17, $21.25

6.3 Answers will vary with the date of the assignment.

6.4 a. With $250,000 to invest, she can build a well-diversified portfolio that would include

some mature profitable companies such as Coca-Cola and Home Depot that pay predictable,

growing dividends, some large, established firms that still have strong growth possibilities such

b. Those with smaller amounts to invest are better off focusing on quality, long-term growth and

less on aggressive stock management. If she were more risk averse, we might want to allocate

more to blue chip stocks than to growth stocks with a weighting such as, such as 75-25 or 60-40.

6.5 The three sources of return to U.S. investors from foreign stocks are shared profits in the form of

dividends, capital gains from increases in the stock’s market price, and the appreciation of the

102 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

a. British pounds and Australian dollars have appreciated in value compared to U.S. dollars, giving

greater returns to the U.S. investor who holds stocks of corporations based in those countries.

6.6 a. A buy-and-hold strategy is a long-term program that seeks capital growth as well as

b. A current-income portfolio focuses on the current dividend yield of stocks. Safety of principal

and stability of income are vital, while capital gains have secondary importance. The benefits of

c. Long-term total return would emphasize more growth stock as well as a lesser percentage in

d. Aggressive stock management would call for a frequent rebalancing of the portfolio weights to

 Solutions to Problems

6.1 Using the approach noted in the chapter, we have:

If an investor owned 200 shares before the split, she would own 334 shares afterward:

The market value of her holdings, however, would be unchanged:

6.2 Commissions on trades. The investor began with $20,000 and made $1,000 on his trade of stock.

This totals $21,000. His balance, however, is $20,900. Therefore, Item 4 should be:

6.3 Book value of common stock  Total assets – Total debt – Preferred stock

For Ron’s Rodents:

6.4 Market capitalization  Share price  Number of shares outstanding

6.5 a. Earnings per share (EPS) 

Net profits after taxes Preferred dividends

Number of shares of common stock outstanding

–

Chapter 6 Common Stocks 103

For Med Tech Co.:

$15,800,000 $1,000,000

EPS $5.92

2,500,000

–

= =

b. Dividend yield 

Cash dividends per share

Market price per share

For Med Tech Co.:

Dividend yield 3.33%

$60

= =

c. Dividend payout ratio 

Dividends per share

EPS

For Med Tech Co.:

Dividend payout ratio 33.8%

$5.92

= =

6.6 Note that for a taxpayer in the 33% tax bracket for ordinary income, the tax rate on dividends and

capital gains is 15%.

Initial Investment  200  $50 $10,000

Sales Proceeds  200  $55 11,000

6.7 a. Book value  Total assets – Total debt – Preferred stock

For Truly Good Coffee:

Book value  $240M – $115M – $25M  $100M

which is equal to common stockholders’ equity.

b. Book value per share 

Book value

Number of shares of common stock outstanding

For Truly Good Coffee:

Book value per share 

$100,000,000 $10 per share

10,000,000 =

c. Earnings per share (EPS) 

Net profits after taxes Preferred dividends

Number of shares of common stock outstanding

–

For Truly Good Coffee:

$22,500,000 $2,000,000

EPS $2.05 per share

10,000,000 shares

–

= =

d. Dividend payout ratio 

Dividends per share

Earning per share

For Truly Good Coffee:

104 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

$.75 36.59%

Chapter 6 Common Stocks 105

6.12 There is no set solution to this problem because the answer will vary with the companies selected by

the student. The students should be encouraged (required?) to actually compute the requested

6.13 a. Holding period return (HPR) 

Ending price Beginning price Current income

Beginning price

– +

(1) (2) (3) (4) (5) (6)

Year

End of

Year

Price

Price at

beginning

of year

Capital

Gain

(1) – (2)

Dividend

Income

Return

(3)  (4)

HPR

(5)/(2)

2012 $54.00 $42.50 $11.50 $0.82 $12.32 28.99%

Over the five-year period, on average Engulf and Devour has returned 27.76% per year. This is

well above the average return on the stock market over the same period.

6.14 a. The expected return on Bayer stock in local currency is (60.00 + 1.50 – 53.25) / 53.25 = 15.5%.

b. There are a couple of ways that we could calculate the return on these two stocks in U.S. dollars.

First let’s focus our attention on Bayer stock.

In a year, Bayer stock will be worth €60 and it will pay €1.50 in dividends, so the end-of-year value is

€61.50. The exchange rate at the end of the year tells us that $1 is worth 1.015 euros, so the ending

value of Bayer in dollars is

To get the return in dollars we can just do the following

Now, we could also calculate the answer using Equation 6.6. However, be careful to read the

sentence just underneath that equation which says, “In Equation 6.6, the “exchange rate” represents

the value of the foreign currency in U.S. Dollars—that is, how much of one unit of the foreign

106 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

currency is worth in U.S. Dollars.” In part (1) of problem 6-14, the exchange rates are not expressed

in terms what one unit of foreign currency is worth in dollars. Instead, they are expressed in terms of

what one dollar is worth in euros. If we want to use Equation 6.4, we have to express the exchange

rates in the right way, which simply means inverting them:

euros per dollar(€/$) dollars per euro($/€)

Now apply Equation 6.4

Now let’s turn to Swisscom. Swisscom stock is currently worth 71.5 francs. The current exchange

rate tells us that 1 franc is worth $0.75, so the dollar value of Swisscom today is

In a year we expect Swisscom to be worth 76 francs, plus it will pay a 1.5 franc dividend. If at the

end of the year 1 franc is worth $0.85, then the end-of-year dollar value of the investment in

Swisscom will be

Which means the total rate of return is

In this part of the problem, the exchange rate is already expressed in terms of how much one unit

of foreign currency is worth in dollars, so we can plug the values directly into Equation 6.6 to get

the answer:

The bottom line here is that once we account for expected currency movements, the better

investment looks like Swisscom rather than Bayer. When you invest your money in a foreign

stock, your investment performs better if the dollar depreciates and the foreign currency

appreciates. That’s what’s happening here. In Germany, the value of $1 is 0.9025 euros when we

buy the stock, but when we expect to sell it we think the value of $1 will be more, 1.015 euros. So

the dollar has appreciated, the euro has depreciated, and the dollar return suffers as a result (i.e.,

the return in dollars is less than the return in euros).

In Switzerland the opposite happens. When we make the investment, 1 Swiss franc is worth $0.75,

but a year later we think 1 Swiss franc will be worth more at $0.85. The franc has appreciated, the

dollar has depreciated, and that makes the dollar return on the Swiss investment even higher than the

return in local currency.

6.15 If the stock falls by 50%, Bruce’s stock would be worth $12,500 ($25,000/2). To get back to $25,000,

the stock would have to increase by 100%.

Chapter 6 Common Stocks 107

 Solutions to Case Problems

Case 6.1 Sara Decides to Take the Plunge

The purpose of this case is to provide the student with the opportunity to identify investment needs,

establish investment goals, and design an investment program.

a. Since Sara is so successful, she can easily provide for the necessities of life. Other than a

minimum savings account to meet emergency needs, her savings should not be held for the long haul

in these accounts. Keeping money tied up in low yielding savings accounts is costly since the lower

yields mean much slower growth of capital—in short, Sara will end up with a lot less money than if

she’d put it into something with a higher return (like stocks). As an aside, Sara should make sure that

any money she keeps in savings (i.e., for emergency purposes) is put into higher yielding short-term

b. Because of her high current income, Sara does not need investments to provide income now. She

does need securities for capital accumulation and as a store of value (protect loss in purchasing power

due to inflation).

1. North Atlantic Swimsuit Company (NASS) might meet Sara’s needs, but it is a highly speculative

stock. The capital accumulation and storage of value benefits from this security are difficult to

2. Town and Country Computer best fills these needs. It is a classic growth firm: It has a long record

3. Southeastern Public Utility Company does not meet Sara’s needs; it has a high current dividend

and low growth prospects. Without at least average growth, the stock cannot serve as a store of

value, since inflation will cause the value of the investment to fall. On the other hand, given the

4. International Gold Mines may serve as a source of capital accumulation, but its price volatility

makes it questionable as a store of value. Certainly, its defensive characteristics make it attractive

during periods of high inflation when the price of gold is increasing. However, when inflation

Of the four options, Town and Country best serves her needs, and Southeastern Utilities is least

attractive. The other two, more speculative stocks, fall in between with their appeal a function

of their long-term growth prospects (NASS) and expectations about inflation (International

Gold Mines).

108 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

c. Sara should follow a buy-and-hold or a quality long-term growth strategy. A high-income strategy

does not fit her needs; she does not have the expertise to handle aggressive stock management

(although her investment adviser might help her here); and the speculative, short-term strategy does

not match her requirements or abilities. Given her new entry into the area of investments, she should

Case 6.2 Wally Wonders Whether There’s a Place for Dividends

This case illustrates the common practice of changing investments in reaction to market changes. This case

should allow students to experience some of the steps involved in following an investment strategy, as it

demonstrates that during an economic downswing, even an investor interested in long-term growth may

have something to gain by going after stocks that offer attractive dividend yields.

a. Wally’s existing plan is one of long-term growth, obtained by investing in quality issues. Given his

b. 1 Expected dividends for Hydro-Electric:

Year

(1)

Expected EPS

(2)

Expected

Dividend Payout Ratio

(3)

(1)  (2)

Expected Dividend

2016 $3.25 40% $1.30

2017 3.40 40 1.36

2. Wally could purchase 100 shares of Hydro-Electric stock ($6,000 investment/$60 per share).

Expected returns would be a function of dividends and capital gains. First, dividend income

over the five years would be:

Year

Dividends

per Share 100 Shares Total

2010 $1.30 100 $130

2011 1.36 100 136

Total dividends for five years: $865

Now assuming he can sell the stock for $80 per share in five years, his 100 shares will bring

$8,000 and his capital gains would be: $8,000  $6,000  $2,000.

Therefore:

Total return  Total dividends  Capital gains

Chapter 6 Common Stocks 109

3. If Wally joins the company’s Dividend Reinvestment Plan, he can obtain shares at reduced prices

and hence can achieve his goal of capital appreciation.

Wally will obtain additional shares as follows:

(1) (2) (3) (4) (5) (6)

Year

No. of Shares

Held at

Beginning

of Year

Dividends

per Share

Total

Dividends

Purchase

Price

per Share

No. of Shares

Purchased

(4)  (5)

2016 100.00 $1.30 $130.00 $50 2.60

2017 102.60 1.36 139.54 55 2.54

Using the Dividend Reinvestment Plan, Wally would have accumulated 15.10 additional shares,

for a total of 115.10 shares by the end of 2011. With the stock trading at $80 on December 31,

2014, his shares would be worth 115.10  $80  $9,208.

Note: The figure shown in column (2) is the number of shares held at the beginning of the year;

this number will increase each year with the dividends reinvested. This increases the total

dividends received each year. Compare this answer with 2b.. Thus, dividend reinvestment plans

have a cascading effect.

c. Wally would not be going to a different investment strategy if he buys the shares of

Hydro-Electric; he would merely be changing the thrust of it. This is a common strategy used by