Solutions for Web Chapter 20: Questions and Problems
WEB CHAPTER 20
AN INTRODUCTION TO SECURITY VALUATION
Answers to Questions
1. The top-down valuation process begins by examining the influence of the general
economy on all firms and the security markets. The next step is to analyze the various
2. It is intuitively logical that aggregate market analysis precede industry and company
analysis because the government and federal agencies can exert influence on the
aggregate economy via fiscal (changes in government spending, taxes, etc.) and monetary
(changing money supply, interest rates, etc.) policy. Further, inflation, another aggregate
3. All industries would not react identically to changes in the economy simply because of
the different nature of business. The auto industry for instance tends to do much better
than the economy during expansions but also tends to do far worse during contractions as
Solutions for Web Chapter 20: Questions and Problems
4. Estimating the value for a bond is easier than estimating the value for common stock
since the size and the time pattern of returns from the bond over its life are known
amounts. Specifically, a bond promises to make interest payments during the life of the
5. The required rate of return on an investment is primarily determined by three major
factors: (1) the economy’s real risk-free rate (RRFR), (2) the expected rate of inflation
(I), and (3) a risk premium (RP). While this basic framework will apply no matter what
country you choose to invest in, there will be significant differences in these factors
among different countries over time. Among the specific reasons why an investor may
6. The nominal risk-free rate (NRFR) is composed of two factors: (1) real risk-free rate
(RRFR) and (2) expected rate of inflation E(I). As mentioned in the answer to question
#5, the real risk-free rate for all countries is an approximation of the economy’s real
Solutions for Web Chapter 20: Questions and Problems
7. No, the Indonesian and United Kingdom stocks should have significantly different risk
premiums. Specifically, Indonesian stocks should have much larger risk premiums
8. No, the Singapore stock should be more risky than the Canadian stock based upon similar
reasoning as presented in Question #7.
9. Student Exercise
10. Student Exercise
11. The relative valuation ratios to evaluate a stock should be used in cases where:
12. The discounted cash-flow valuation approaches can be used for stocks that pay dividends,
particularly in the case of a stable, mature firm where the assumption of relatively
constant growth for the long term is appropriate.
13. The two valuation approaches should not be considered to be competitive approaches;
rather the text suggests that both approaches should be used in the valuation of common
stock. The discounted cash flow techniques reflect how we describe value, that is, the
Solutions for Web Chapter 20: Questions and Problems
WEB CHAPTER 20
Answers to Problems
1. Assume semiannual compounding:
Par value $10,000
Coupon Payment (every six months) $450
2. If the required return rises to 11%, then:
Number of periods 20
3. Annual dividend $9.00
Required return 11%
4. Earnings per share: last year $10.00
Dividends per share: last year $6.00
Estimated earnings per share: this year $11.00
Solutions for Web Chapter 20: Questions and Problems
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Therefore, the present value of BBC’s share is:
5. Earnings per share: last year $10.00
Dividends per share: last year $6.00
Required rate of return 8%
Expected sell price $110.00
7. Estimated earnings per share $11.00
Dividend payout ratio 60%
Required rate of return 11% (same as problem #6)
Growth rate of dividends 9%
8. Dividend payout ratio 40%
Return on equity 16%
= 9.6%
9. Dividend payout ratio 40%
Dividend growth rate 9.6%
Required rate of return 13%
11.
Leveragex Turnover Asset Total Margin x Profit
Equity
Assets Total
x
Assets Total
Sales
x
Sales
IncomeNet
ROE
=
=
Solutions for Web Chapter 20: Questions and Problems
– 158 –
12. Although grocery chains realize a very low profit margin because of heavy competition
(around 1%), they do enjoy a very high asset turnover ratio. Combined with prudent use
of leverage, it is indeed possible for them to achieve a ROE of about 12%.
13. Student Exercise
However, if ROE = .19 and RR = .60,
then growth rate = .60 × .19 = .114
If next year’s earnings are expected to be: $5.57 = $5.00 × (1 + .114)
Applying the P/E: Price = (15.38) × ($5.57) = $85.69
Thus, you would be willing to pay up to $85.69 for Moncton Computer Company stock.
x38.1538.15
026.
40.
.114–.14
.40
P/E ====
Solutions for Web Chapter 20: Questions and Problems
– 159 –
The present value of the stock is:
15(b). Growth rate 8%
Required rate of return 12%
16. Student Exercise