/55

Question 1 (18 marks)

Use the data set “Beta Calculation” in D2L, to calculate stock betas for the stocks
included using the Single Index Model. GSPTSE is the S&P/TSX Composite Index and
will act as the “Market Portfolio”. You will need to use the Data Analysis Pack in Excel
to solve a regression.

a. Create a new worksheet with the regression output of each regression (one for
each stock). Label each one with its ticker symbol. Highlight the beta in each
one. (8 marks)

Completed in the Excel file attached.

b. Which stock has the highest Beta? Does this match your expectations? (2 marks)

CGX has the highest Beta (2.481). This Beta matches my expectations.

c. Which stock has the lowest Beta? Does this match your expectations? (2 marks)

L has the lowest Beta (0.1583). This Beta matches my expectations.

d. Based on the R2 value, overall, how well does the S&P 500 index explain the
variance in the stock returns? (1 mark)

The R-squared values vary significantly, with the highest being MG at 0.5462 and
the lowest being L at 0.0200. This observation suggests that for some stocks, such
as MG, the S&P 500 index is a better predictor of stock returns, explaining over
54% of the variance, while for others, like L, it explains almost none of the
variance.
 e. Do you think a multifactor model would do a better job in predicting future
returns? Why or why not? (2 marks)

A multifactor model may do a better job predicting future returns for stocks with
low R-squared values from the Single Index Model because it would incorporate
additional factors such as size and value factors that could account for the
variance in stock returns that the market index alone does not.

f. Your analysis of the upcoming year is that you expect market growth to stagnate
and possibly enter a period of slight recession? Based on this expectation, which
of the stocks would you choose to invest in if you used sector rotation? (3 marks)

With market growth expected to stagnate or recede, I will choose to invest in

stocks with low betas, as these would be expected to be less volatile in a
downturn. L, with the lowest beta of 0.1583, would likely be less affected by
market swings and might be a safer option in a sector rotation strategy during a
period of stagnating or declining market growth.
Question 2 (6 marks)

Assume you have a 1-year investment horizon and are trying to choose among three
bonds. All have the same degree of default risk and mature in 10 years. The first is a
zero-coupon bond that pays $1,000 at maturity. The second has an 8% coupon rate and
pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100
coupon once per year.

a. If all three bonds are now priced to yield 8% to maturity, what are their prices?
(3 marks)

Zero Coupon Bond:

B o=
[ 1000
( 1+0.08 )10]=$ 463.19

8% Coupon Bond:
B0=80 × ¿

10% Coupon Bond:

 B0=100 × ¿

b. If you expect their yields to maturity to be 8% at the beginning of next year,

what will their prices be then? (3 marks)

Zero Coupon Bond:

B o=
[ 1000
( 1+0.08 )9]=$ 500.25

8% Coupon Bond:
B0=80 × ¿

10% Coupon Bond:

B0=100 × ¿
Question 3 (7 marks)

Based on sector rotation strategy, what is the best timing in the business cycle to invest in
the following industries?
a. Technology
The best timing is during the early recovery stage as businesses invest in new
technologies to encourage growth.
b. Energy
The best timing is during the early expansion stage when demand starts to
increase.
c. Gold mining
The best timing is during the early recovery phases as it is perceived as a
safe-haven asset.
 d. Construction
The best timing is during the early to middle stages of expansion as economic
activity increases and infrastructure spending grows.
e. Steel production
The best timing is during the middle stages of expansion when construction
and manufacturing demand is higher.
f. Banking/Finance
The best timing is during the mid-to-late expansion when interest rates may
rise, thus, improving profit margins.
g. Luxury goods
The best timing is during the late expansion phase since consumer confidence
and disposable incomes are higher.

Question 4 (10 marks)

The market consensus is that Analog Electronic Corporation has an ROE=9%, a beta of
1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3. This year’s
earnings were $3 per share. The annual dividend was just paid. The consensus estimate
of the coming year’s market return is 14%, and current T-bills currently offer a 6%
return.

a. Find the price at which Analog stock should sell. (4 marks)

Given the following information:

rf =6 %=0.06
β=1.25
E ( rM ) =14 %=0.14
k =rf + β [ E ( rM ) – rf ] =0.6+1.25 x ( 0.14 – 0.06 )=0.16∨16 %
g=ROE x b=0.09 x (2/3)=0.06=6 %

D1=E o x (1+ g) x(1−b)

 1
$ 3 x 1.06 x =$ 1.06
3
D1
Po =
( k – g)
¿ $ 1.06/(0.16 – 0.06)=$ 10.60
Thus, the Analog stock should sell at $10.60.

b. Calculate the leading and trailing P/E ratios. (2 marks)

Po $ 10.60
Leading = =$ 3.33
E1 $ 3.18
P o $ 10.60
Trailing = =$ 3.53
E o $ 3.00

c. Calculate the present value of growth opportunities. (1 mark)

E1
PVGO=P o –
k
$ 3.18
¿ $ 10.60−
0.16
¿ $ 10.60−$ 19.875
¿−$ 9.28

d. Suppose your research convinces you Analog will announce momentarily that
it will immediately reduce its plowback ratio to 1/3. Find the intrinsic value
of the stock. (2 marks)
1
Revised plowback ratio b=
3
1
g=ROE x b=0.09 x =0.03∨3 %
3

D1=E o x (1+ g) x(1−b)

2
$ 3 x 1.03 x =$ 2.06
3
 D1
V o=
( k – g)
¿ $ 2.06/(0.16 – 0.03)=$ 15.85

e. The market is still unaware of this decision. Explain why V0 no longer

equals P0 and why V0 is greater or less than P0. (1 mark)

V o no longer equals Po and V o is greater than Po since the firm spends more
earnings and reinvests them at a low Return on Equity (ROE).

Question 4 (7 marks)

The Duo Growth Company just paid a divided of $1 per share. The dividend is expected
to grow at a rate of 25% per year for the next three years and then to level off to 5% per
year forever. You think the appropriate market capitalization rate is 20% per year.

a. What is your estimate of the intrinsic value of a share of the stock? (4

marks)

D0=$ 1
The growth rate for first 3 years is 25%, followed by a constant growth rate (g)
of 5% forever.
D1=$ 1.0000 ×1.25=$ 1.2500
D2=$ 1.2500 ×1.25=$ 1.5625
D3=$ 1.5625 ×1.25=$ 1.9531
D4 =$ 1.9531× 1.05=$ 2.0508

Market Capitalization Rate , k=20 %

 D4
P 3=
( k −g )
$ 2.0508
P 3=
( 0.20−0.05 )
P3=$ 13.6720
$ 1.25 $ 1.5625 $ 1.9531 $ 13.6720
P 0= + + + =$ 11.17
1.20 1.20
2
1.20
3
1.20
3

Thus, Intrinsic Value of Stock is $11.17.

b. If the market price of a share is equal to this intrinsic value, what is the
expected dividend yield? (1 mark)

D1 $ 1.2500
Expected Dividend Yield= = =0.112× 100=11.2% .
P 0 $ 11.17

c. What do you expect its price to be one year from now? (2 marks)

$ 1.5625 $ 1.9531 $ 13.6720

P 1= + + =$ 12.15
1.20 1.20
2
1.20
2

Question 6 (7 marks)

SilX is a computer chip firm with several profitable existing products as well as some
promising new products in development. The company earned $1.50 per share last
year, and just paid out a dividend of $0.75 per share. Investors believe that the
company plans to maintain its dividend payout ratio at 50%. ROE equals 20 percent.
Market consensus seems to be that the current situation will persist indefinitely.
a. What is the market price of SilX stock? The required return for the company chip
industry is 15 percent and the company has just gone ex-dividend. (2 marks)

D
P=
( r−g)
Where:
P = Market price of the stock
D = Expected dividend for the next period
r = Required rate of return
g = Constant growth rate of dividends
 Given:
The company just paid a dividend of $0.75 per share.
The dividend payout ratio is 50%.
Earnings per share (EPS) = $1.50
Required rate of return (r) = 15%
The company plans to maintain its dividend payout ratio at 50%.
Since the payout ratio is constant at 50%, the growth rate of dividends (g) will be
equal to the growth rate of earnings.
Assuming the company's situation will persist indefinitely, the growth rate of
earnings (g) is expected to be zero.
D=EPS × Payout ratio
D=$ 1.50 × 0.5=$ 0.75
Substituting the values in the perpetuity formula:
P=D /(r −g)
P=$ 0.75 /(0.15−0)=$ 5.00
Therefore, the market price of SilX stock is $5.00 per share.

b. Suppose you discover the SilX’s competitor has developed a new chip that will
eliminate SilXs current technological advantage in this market. This new product,
which will be ready to come on the market in 2 years, will force SilX to reduce
the prices of its computer chips to remain competitive. This will decrease ROE to
15% and, because of falling demand for its products, SilX will decrease the
plowback ratio to .40. The plowback ratio will be decreased at the end of the
second year, at t=2; the annual year-end dividend for the second year (paid at t=2)
will be 60 percent of that year’s earnings. What is your estimate of SilX’s
intrinsic value per share? (Hint: prepare a table of SilX’s earnings and dividends
for each of the next 3 years. Pay close attention to the change in the payout ratio
in t=2.) (5 marks)

Given:
Current ROE = 20%
After the competitor's product launch (in 2 years), ROE will decrease to 15%.
The payout ratio will be decreased to 40% at the end of the second year (t=2).
The dividend for the second year (paid at t=2) will be 60% of that year's earnings.

Year 0 (current year):

Earnings per share (EPS) = $1.50 (given)
Dividend per share = $0.75 (given

Year 1:
Assuming no change in earnings and dividends
EPS = $1.50
Dividend per share = $0.75 (50% of $1.50)

Year 2:
ROE decreases to 15%, but the payout ratio remains at 50% for this year.
EPS=Previous year ' s EPS ×(1+ ROE)
EPS=$ 1.50 ×(1+0.15)=$ 1.725
Dividend per share=60 % of $ 1.725=$ 1.035

Year 3 and beyond:

ROE = 15%
Payout ratio = 40%
EPS=Previous year ' s EPS ×(1+ ROE)
EPS=$ 1.725 × (1+ 0.15 )=$ 1.984
Dividend per share=$ 1.984 × 0.4=$ 0.794

Here's a table of SilX's earnings and dividends for the next three years:

Year EPS Dividend Payout Ratio ROE

0 $1.50 $0.75 50% 20%

1 $1.50 $0.75 50% 20%

2 $1.725 $1.035 60% 15%

3 $1.984 $0.794 40% 15%

To estimate the intrinsic value per share, we can use the dividend discount model
with a three-stage growth pattern:
Stage 1 (Year 1): Constant dividend of $0.75
Stage 2 (Year 2): One-time dividend of $1.035
Stage 3 (Year 3 and beyond): Constant growth rate of dividends at
g=ROE × ( 1−Payout ratio )
g=0.15× ( 1−0.4 )=0.09∨9 %
Using the dividend discount model formula:
 ( ) D3

( )(
Intrinsic Value=
D1
( 1+r )
+
D2
) +
r−g
( 1+ r )2 ( 1+r )2
Where:
D 1=Dividend∈Year 1=$ 0.75
D 2=Dividend∈Year 2=$ 1.035
D 3=Dividend ∈Year 3=$ 0.794
r =Required rate of return=15 %
g=Constant growthrate of dividends ¿ Year 3 onwards=9 %
Substituting the values:

( )
$ 0.794

(
Intrinsic Value=
$ 0.75
1.15 )(
+
$ 1.035
1.15
2
+
)
0.15−0.09
( 1+ 0.15 )2
$ 15.880
Intrinsic Value=$ 0.652+ $ 0.782+ =$ 13.434
1.3225
Thus, the SilX’s intrinsic value per share is $13.434.