Question

adjust rapidly to new information UI the efficient markets hypothesis J. future stock returns cannot be predicted from any information that is publicly aaese C. corporate insiders should have no better investment performance than allowed to trade freely D. A andB E. B and C other investors even if f-A nswer Questions (3 questions, 15 points, suggested time 15 minutes) wer each question in two to three sentences 5 points) When is a company's value of growth (PVGO) a negative mumber (ie, when does higher gowh result in a lower stock price)? (5 points) A stock's forward P/E ratio is higher than the average P/E ofall of the companies in its industry Does this mean that the stock is over-valued (priced too high)? Briefly explain your answer. In discussing a mutual fund's performance, what is meant by the term "turnover"? Is higher or lower turnover better for mutual fund investors? Explain why. blems (6 questions, 55 points, suggested time 55 minutes) full credit on the problems, show all work and label answers clearly. Show in detail how you wers: show the formulas you use and your arrive at yous document assumptions. (12 points) Your predictions for the returns on two stocks are summarized in the table below: Return on Stock A Scenario Probability Stock B (25) .09 Recessiorn Slow growth Moderate growth High growth So 11 Standard deviation 250 .050 Beta 1.40 he covariance of the two stocks is .01 and their correlation coefficient is .80. If you invest 40% of your rtfolio in stock A and 60% of your money in stock B, what will be your portfolio's a. Expected return? b. Standard deviation? C. Beta? er's margin requirements for short sales are 60% initial margin and 40% maintenance margin. a. How much will you need to deposit in your margin account when you do the short sale? b. On a per-share basis, what will your dollar profitloss be if the stock's price rises to $75 oints) A stock is currently selling for $60 a share. You decide to short-sell 300 shares of the stock. Your (This is the same as asking a Hou far can the stock's price rise before you get a margin call? tly cqual to the margin required by your broker.)

Answer 1

For investors, company growth is desirable only if it increases their return on investment—either its stock price and/or its dividends increase. According to the dividend discount model, it is possible for a company to grow while its stock price declines. A company's stock price will increase only if the company can reinvest the money and earn a higher rate of return than the required rate of return demanded by investors. The additional growth of a company's earnings has net present value of growth opportunities (PVGO).

If its ROE is greater than the required rate of return, then its PVGO exceeds zero, and the stock price will increase if the company reinvests some of its earnings for further growth. If the PVGO is zero, meaning that the ROE equals the capitalization rate, then it makes no difference to the stock price if earnings are reinvested or not; however, an earnings retention rate greater than that necessary to maintain liquidity will lower the dividend without increasing the stock price. If PVGO is negative, then the company will still grow, but its overall ROE will decline, and with it, its stock price. Therefore, the company should distribute most of its earnings as dividends, since that will yield the greatest return for stockholders.

PVGO is value over E/r. Note that E/r is simply the value of a company that is not growing i.e. PV of a perpetuity. Such would be the case when the company distributes all of its earnings - it would not grow - and hence PVGO is zero. When PVGO is anything other than zero (positive or negative), it does not distribute all of the earnings. If retained earnings are invested in positive npv projects (or market expects it to), PVGO>0. If retained earnings are squadered in negative NPV projects, PVGO<0.

If retained earnings are invested in 0 NPV projects, PVGO would (still) be zero.

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