Financial Management Case

FIN501 Winter 2012, Assignment #3 Due Date: March 22nd, Thursday in class.

Note: You have the option to form a group to complete this assignment. It is also fine if you choose to do it independently. For people who choose to do it with the group, please make sure you share the work and know what is going on with each question. You only need to turn in one copy with everyone's names on it. Each group should NOT exceed THREE people.

Excel output is accepted. However, calculation by hand is beneficial since you will not have access to excel in the exam.

1. ARIS Corp. just paid a dividend of $1.00 (Div0).  The company is expected to experience abnormally high growth in the next three years: 30 percent in the first two years, 20 percent in the third year. After that the growth is expected to settle down to 5 percent per year forever. Assuming a discount rate of 10%, compute the current price of the stock

2. NoDeal Inc has just paid a dividend (Div0) of $2.25 per share. Its stock is priced today at $39 (remember, our default assumption is that the stock price is ex dividend i.e. the $39 price does not include the $2.25 dividend just paid). If investors require a 10% return on NoDeal equity (rE = 10%), what is the expected rate of dividend growth? (this is based on constant dividend growth model)

3. Analysts expect that TexMex Restaurants Inc. (TMR) will report earnings of $16 million one year from today. TMR’s policy is to pay 70% of its earnings out in dividends (it paid its dividends already for this year). The company has 8,000,000 shares outstanding and the book value of its equity is $160 million. Its required rate of return is rE = 12%. Assume that the numbers above are representative of the foreseeable future, and that TMR’s ROE is a good estimate of the company’s Return on New Investment. (ROE=Earnings/Book value of equity)

1. What will the stock price be three years from now? (using constant dividend growth model for future price)
2. Suppose the board of directors decided to change the dividend policy and pay out 100% of TexMex’s earnings (so TexMex would pay out the full $16 million in dividends next year and then maintain the new dividend policy forever). Would shareholders benefit from this decision?

4.Consider the following two stocks with end-of-period possible returns:

State       Probability of state      Return on Stock 1              Return on Stock 2

1                   0.30           22%          10%

2                0.20           17%            20%

3                0.25           10%          -8%

4                0.25          -10%           3%

Compute the following:

1. The expected return of each stock

1. The standard deviation of each stock

1. The (i) expected return and (ii) standard deviation on a portfolio (call it Portfolio P) where 60% of the capital is invested in stock 1 and 40% is invested in stock 2.  Note that the correlation coefficient between the two stocks is 0.40.

1. Suppose the T-bill rate (or risk-free rate) is 3%. Compute the (i) expected return and (ii) standard deviation on a complete portfolio (call it Portfolio C) that has 30% invested in T-bills and 70% invested in portfolio P (the same P in part C above).