20X1 20X2 20X3 EBITDA* 80 95 110 Depreciation and amortization 20 22 25 Pre tax operating profit 60 73 85 Capital investment 12 30 30 * EBITDA = Earnings before interest, taxes, depreciation and amortization. 20X4 120 28 92 20 The estimates are for the end of the next 4 years and the estimates for year 4 are expected to remain constant for subsequent years. The amounts are in millions of dollars. Additional information:
? Company XYZ has $400,000,000 of debt ? Company XYZ has 1,000,000 shares outstanding.
? For this kind of investment opportunity, the firm considers that its weighted average cost of capital
defined as:
?D??E?WACC???rdebt?(1?TC)????requity??V??V? to be 7.40% ?
? The corporate tax rate is 40 percent. Required:
a. Calculate the value of Company XYZ in millions of dollars. b. Calculate the intrinsic value of a share in Company XYZ
T4Q4.
Twenty years after the original Fama-French model, Fama and French (2013) have proposed a new, five-factor model, incorporating two additional factors, RMW and CMA. RMW (robust-minus-weak) is the difference in returns between a portfolio of firms with robust and weak profitability; CMA (conservative-minus-aggressive) is the difference in returns between a portfolio of firms with conservative (i.e. low) and aggressive (i.e. high) investment. Recall the constant growth dividend discount model:
E1 1?b P0= r?gThe economic intuition behind why HML, CMA and RMW are risk “premiums” can be derived easily from the above fundamental valuation formula. Explain how.
Questions based on week 5 topics (no submission is required in week 6)
T5Q1.
Investors expect the market rate of return in the coming year to be 14%. The T-bill rate is 6%. The stock has a beta of .7. The market value of its outstanding equity is $100 million.
a. If the stock is fairly priced, what is the expected rate of return on this stock?
b. If the market return in the coming year actually turns out to be 10%, what is your best guess
as to the rate of return that will be earned on the stock?
c. Suppose that the company wins a major lawsuit during the year. The settlement is $5 million.
The stock return during the year turns out to be 12%. What is our best guess as to the settlement the market previously expected the company to receive from the lawsuit (assume that the market return in the year turned out to be 10%). The magnitude of the settlement is the only unexpected firm-specific even during the year. T5Q2.
Good News, Inc., announces that its annual profit for the past year was $2.5 million. The market?s consensus forecast for its profit prior to the announcement was $2.2 million. There has been no other price-relevant information about Good News Inc. released to the market.
a. If the market is efficient, how does the share price change when the market reopens the next
morning? Can you describe/ show the share price behaviour before, at the time of, and after the announcement?
b. If the share price change does not occur until two hours after the market opens. Is this
consistent with an efficient market? and why ? How to make profits from this scenario?
c. Market analysts believe that the profit announcement should cause the share price to change
by $1.60. However, the share price changes two hours after the market opens is actually $1.80. What type of price reaction is this? As a result of this price reaction, what do you expect to happen to the share price in the longer term? T5Q3.
Behavioral biases affect investor decisions.
a. Can you list any behavioral biases and give some examples (at least two)?
b. As we know that many investors have behavioral biases, is it possible that stocks might be
priced efficiently? Are there some factors that may limit the arbitrage activities of rational investors?
c. Even though both advocates of the efficient market hypothesis and behavioral finance agree
that indexing is the optimal investment strategy, they have different reasons for this conclusion. Can you discuss this?
T5Q4.
The semi-strong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information?s full effects.
a. Identify and explain two examples of empirical evidence that tend to support the EMH
implication stated above.
b. Identify and explain two examples of empirical evidence that tend to refute the EMH
implication stated above.
c. Discuss reasons why an investor might choose not to index even if the markets were, in fact,
semi-strong form efficient. T5Q5
a. With regard to market efficiency, what is meant by the term \
of market anomalies and explain why each is considered to be an anomaly. b. Compare and contrast the efficient market hypothesis with the school of thought termed
?behavioral finance?.
Questions based on week 6 topics due in week 7
T6Q1.
a. b. c. d.
Compare & contrast fundamental analysis and technical analysis
What are the principal criticisms of fundamental analysis? And technical analysis? Briefly outline the main assumptions that underline technical analysis.
Which assumption do you consider is the most important for technical analysis? Which assumption do you think is the most controversial?
e. What are the main criticisms of technical analysis? What about fundamental analysis?
f. One of the main assumptions of technical analysis is that prices discount everything. The
Efficient Market Hypothesis (EMH) essentially states that the current price reflects all information that is relevant to the security. Critically evaluate and explain whether this means that the EMH justifies technical analysis?
g. Describe some of the key measures used in technical analysis and what they measure
T6Q2. - Behavioural Finance
Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paidfor them. She believes that if she just holds on to them a little longer they will recover, at whichtime she will sell them. What behavioural characteristic does Davis have as the basis for her decisionmaking? a. Loss aversion. b. Conservatism. c. Representativeness.
T6Q3. After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis forher decision making? a. Fear of regret. b. Representativeness. c. Mental accounting.
T6Q4. All of the following actions are consistent with feelings of regret except: a. Selling losers quickly. b. Hiring a full-service broker. c. Holding on to losers too long.
T6Q5.
Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment in the metropolitan area. During an initial discussion of the Maclins? financial plans,
Christopher Maclin makes the following statements to the Maclins? financial adviser, Grant
Webb:
a. “I have used the Internet extensively to research the outlook for the housing market over thenext 5 years, and I believe now is the best time to buy a house.”
b. “I do not want to sell any bond in my portfolio for a lower price than I paid for the bond.” c. “I will not sell any of my company stock because I know my company and I believe it has excellent prospects for the future.”
For each statement ( a)–( c ) identify the behavioral finance concept most directly exhibited. Explain how each behavioral finance concept is affecting Maclin?s investment decision making. T6Q6
Suppose Baa-rated bonds currently yield 6%, while Aa-rated bonds yield 5%. Suppose that dueto an increase in the expected inflation rate, the yields on both bonds increase by 1%. Whatwould happen to the confidence index? Would this be interpreted as bullish or bearish by atechnical analyst? Does this make sense to you?
T6Q7
Yesterday, the Dow Jones industrials gained 54 points. However, 1,704 issues declined in pricewhile 1,367 advanced. Why might a technical analyst be concerned even though the marketindex rose on this day?
T6Q8
If the trading volume in advancing shares on day 1 in the previous problem was 330 millionshares, while the volume in declining issues was 240 million shares, what was the trin statisticor that day? Was trin bullish or bearish?