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Equity:ConceptsandTechniques
11. a.
IntrinsicP/Eratio
P0 1
b(ROE r )
1
.
E1 r
r ROE b
Inthiscase,b0,becausethecompanypaysoutallitsearnings.So,P0 /E 11/r1/0.137.69.
b. Again,P0 /E 11/r1/0.137.69.
c. Itisclearfromtheexpressioninpart(a)thatifb0,theintrinsicP/Evalueisindependentof
ROE.Tofurtherexplorethis,realizethattheintrinsicP/EvaluecanalsobeexpressedasP0 /E 1
(1/r)FFG,wherethefranchisefactorisFF(ROEr)/(ROEr)or1/r1/ROE,andthe
growthfactorisGg/(rg).Ifb0,theng0,andtherefore,thegrowthfactorG0.Thus,
regardlessofhowbigtheROEandconsequentlythefranchisefactorFFis,thefranchise
value,FFG,iszero,andtheintrinsicP/Evalueissimply1/r.
d. Again,P0 /E 11/r1/0.137.69.
e. Inpart(d),ROEr13%.Itisclearfromtheexpressioninpart(a)thatifROEr,theintrinsic
P/Evalueisindependentoftheretentionratio,b.Tofurtherexplorethis,letusagainlookatthe
expressionforintrinsicP/Evaluediscussedinpart(c).IfROEr,thenthefranchisefactor
FF0.Thus,regardlessofhowlargetheretentionratioandconsequentlythegrowthfactorG
is,thefranchisevalue,FFG,iszero,andtheintrinsicP/Evalueissimply1/r.
20. a.
Accordingly,
E ( RA ) 4% 1 5% 1 1% 10%
E ( RB ) 4% 1 5% 0 1% 9%
E ( RC ) 4% 1.2 5% 0.5 1% 10.5%
E ( RD ) 4% 1.4 5% 0.5 1% 10.5%
b. Stocksthatshouldbepurchasedarethosewithaforecastedreturn,higherthantheirtheoretical
expectedreturn,giventhestocksriskexposures.Becausetheforecastedreturnsgivenintheproblem
arethereturnsinSwissfrancs,weneedtoconvertthemtodollarreturnsfirst.WeexpecttheSwiss
franctoappreciaterelativetothedollarby2percent.Therefore,usingalinearapproximation,the
dollarreturnisthereturninSwissfrancs2percent.Thefollowingtablesummarizestheforecasted
returnsinfrancsandindollars,andthetheoreticalexpectedreturns
indollars[computedinPart(a)].
StockA StockB StockC
Forecastedreturn(infrancs)
Forecastedreturn(indollars)
Theoreticalexpectedreturn(indollars)
8%
10%
10%
9%
11%
9%
11%
13%
10.5%
StockA
7%
9%
10.5%
Lookingatthistable,wefindthatthebrokerforecastssuperiorreturnsforStocksBandC.
Therefore,theyshouldbebought.Conversely,StockDshouldbesold.
Chapter8
TheCaseforInternationalDiversification
3. a.
Foreachportfolio,expectedreturniscalculatedusingEquation9.1,andportfoliostandard
deviationiscalculatedusingEquation9.2.Expectedreturnsandstandarddeviationsforthe
portfoliosarelistedinthefollowingtable.
When = 0.5:
Investedin
Asset1
Investedin
Asset2
PortfolioExpected
Return
Portfolio
Risk
100%
0%
10.00%
14.00%
80%
20%
11.20%
13.10%
60%
40%
12.40%
12.86%
50%
50%
13.00%
13.00%
40%
60%
13.60%
13.31%
20%
80%
14.80%
14.41%
0%
100%
16.00%
16.00%
b. Foreachportfolio,expectedreturniscalculatedusingEquation9.1,andportfoliostandard
deviationiscalculatedusingEquation9.2.Expectedreturnsandstandarddeviationsforthe
portfoliosarelistedinthefollowingtablesforvariouscorrelations.
When = 1.0:
Investedin
Asset1
Investedin
Asset2
PortfolioExpected
Return
Portfolio
Risk
100%
0%
10.00%
14.00%
80%
20%
11.20%
8.00%
60%
40%
12.40%
2.00%
50%
50%
13.00%
1.00%
40%
60%
13.60%
4.00%
20%
80%
14.80%
10.00%
0%
100%
16.00%
16.00%
When = 0:
Investedin
Asset1
Investedin
Asset2
PortfolioExpected
Return
Portfolio
Risk
100%
0%
10.00%
14.00%
80%
20%
11.20%
11.65%
60%
40%
12.40%
10.56%
50%
50%
13.00%
10.63%
40%
60%
13.60%
11.11%
20%
80%
14.80%
13.10%
0%
100%
16.00%
16.00%
When = 1.0:
Investedin
Asset1
100%
Investedin
Asset2
0%
PortfolioExpected
Return
Portfolio
Risk
10.00%
14.00%
c.
80%
20%
11.20%
14.40%
60%
40%
12.40%
14.80%
50%
50%
13.00%
15.00%
40%
60%
13.60%
15.20%
20%
80%
14.80%
15.60%
0%
100%
16.00%
16.00%
ThegraphsforParts(a)and(b)illustratethat,holdingallelseconstant,lowercorrelations
translateintolowerlevelsofportfoliorisk,withoutsacrificingexpectedreturn.
5.a. Ifthecorrelationbetweenstockmarketreturnsandexchangeratemovementswereequaltozero,the
dollarvolatilityoftheGermanstockmarketwouldbe