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QUESTION BANK ON CF-1 ON BOND & STOCK VALUATION

Q 2. The risk-free rate of return, Rf, is 9%. The expected rate of return on the market portfolio is 13%. The expected rate of growth for the dividend of firm A is 7% in perpetuity. The last dividend paid on the equity stock of the firm was Rs.2.00. The beta of  firm A’s equity stock is 1.2.  Answer the followings :

(a) What is the equilibrium price of the equity stock of firm A ?

(b) How would the equilibrium price change when (i) the inflation premium increases by 2%, (ii) the expected growth rate increases by 3 more %, and (iii) the beta of A’s equity rises to 1.3.

Q 3. Explain clearly with the help of diagrams how/under what conditions the required return of a security changes due to movement along the Security Market Line (SML) and shift of the Security Market Line (SML).

Q 4. The expected return on the market is 12%, with a standard deviation of 21%. The risk-free rate is 8%. Information is available for the following five stocks :

:: 2 ::

1. Calculate the required return, R(ri) for each stock.
2. With these required returns and betas, think of a line connecting them – what is this line ?
3. Assume that an investor, using fundamental analysis, develops the estimates labeled E(ri) for these stocks. Determine which are undervalued and which are overvalued.
4. What is the market’s risk premium (per unit risk) ?

Q 5. Given the following information : Exp. Return of market, E(rm),  12%, Standard Deviation (SD) of market, 21%; Risk-free rate, Rf, 8%; Correlation Coefficient between :

Stock A & market, 0.8, Stock B & market, 0.6, SD of stock A, 25%; SD of stock B, 30%.

1. Calculate beta for stock A & B
2. Calculate the required return for each stock

Q 6. Assume that the risk-free rate is 7% and exp. market return is 13%. Show that the security market line (SML) is : R(ri) = 7.0 + 6.0β .

Assume that an investor has estimated the following values for six different corporations:

Calculate the R(ri) for each corporation using the SML and evaluate which securities are overvalued and which are undervalued.

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