The Dividend Discount Model:

I. is primarily used to price mature stocks.

II. assumes constant dividends.
III. assumes a constant dividend payout ratio.
IV. works only if the growth rate is higher than the expected rate of return.

* III only
* IV only
* III & IV
* I & II
* II only
* I & IV
* I only
That answer is correct!

DDM assumes a constant growth in dividends but does not require the payout
ratio to be constant. Also, it is applicable only when the constant growth rate is
lower than the expected rate of return (It does not preclude the growth rate from
exceeding the expected rate of return over some periods. However, in that case,
the formula that arises from the assumption of constant growth rate cannot be
used).

Which of the following assumptions are required by the efficient markets theory?

I. A large number of profit-maximizing market participants analyze and value

securities.
II. New information arrives in random and independent fashion.
III. All available information is reflected in current prices.

* I & II
* I, II & III
* II only
* II & III
* III only
* I only
That answer is correct!

Note that III is not an assumption but a conclusion of the efficient markets theory.
It follows from assumptions (I) and (II).

Suppose a researcher observes the following strategy in his studies:

If a company has been doing poorly and its CEO is deposed suddenly, buy its
stock 5 days after the announcement and sell it after a month. On the other hand,
if the company has been doing well, short-sell the stock 5 days after the
announcement and close out the position after a month.

He finds that over the past 5 years, this strategy has yielded significantly positive
abnormal returns. Which of the following statements is consistent with the
above?
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I. The results are due to data-mining.
II. The market is not efficient in the semi-strong sense.
III. The market is not efficient in the weak-form sense.
IV. The results are due to an improper model of risk and return.

* I, III & IV
* I & III
* IV only
* I, II & IV
* II only
* III only
* I only
* I, II & III
That answer is correct!

The fact that a strategy has worked in the past does not automatically mean that
markets are inefficient. With potentially tens of thousands of schemes being
tested by hundreds of researchers, it shouldn't be surprising that there will be
many schemes which appear to be money-making machines. Only if the scheme
holds for a very long period of time and works "out-of-sample" will it even be a
candidate for challenging market efficiency. Further, there is also a concern that
the model used to adjust for risks might be an incomplete model in that it does
not capture all the sources of risk (e.g. CAPM vs. the Fama-French 3-factor
model).

Of course, it is also possible that markets are inefficient. In this case, the fact that
a public piece of information like the deposition of the CEO is not impounded in
the price of the stock 5 days after it becomes knowledge could indicate a
violation of the semi-strong form of market inefficiency, though not the weak-
form.

The P/E ratio of a stock equals 7.1. The company has just released its earnings
figures at $12.2 per share. The firm's dividend payout ratio is 28%. If the current
stock price is $100, what is its 1-year HPY under the Dividend Discount Model?

* none of these answers

* 14.83%
* 19.40%
* 13.65%
That answer is incorrect.
Correct answer:
19.40%

It is important to remember that the P/E ratio is the ratio of the current stock price
and next year's expected earnings. Therefore, the firm's expected earnings next
year equal 100/7.1 = $14.09 per share. Since the current earnings equal $12.2, the
dividend growth rate equals (14.09/12.2 - 1) = 15.45%.
To get the 1-year HPY, first calculate the expected price next year. Under DDM, the
P/E ratio remains constant if the firm makes no policy changes and there are no
market disruptions. Therefore, price next year is expected to be $14.09*(1 +
2
15.45%)*7.1 = $115.45. The dividend next year equals $14.09 * 0.28 = $3.95 per
share. Thus, 1-year HPY = (115.45 + 3.95)/100 - 1 = 19.4%.

S&P 500 sales have been estimated at $723 per share while the operating profit
margin has been estimated at 16.6%. The average tax rate on S&P 500 companies
is about 40%, with an average depreciation of 4.7% and an interest expense of
1.3%, all expressed as a percentage of sales. The average payout ratio on S&P
500 is 17%. Assuming a 2.8% growth rate in the economy and an investor demand
of 12% return on equity, the per share S&P 500 must be valued at:

* $79.11
* $87.34
* $84.96
* $123.22
That answer is incorrect.
Correct answer:
$87.34

operating profits = Earnings before depreciation, interest & taxes = EBDIT

and operating profit margin = EBDIT/net sales. Therefore,

net income/sales = (EBDIT/sales - depreciation/sales - interest/sales)*(1-tax rate)

= (16.6% - 4.7% - 1.3%)*(1-40%) = 6.36%.

Thus, earnings = 6.36% * 723 = $45.98 per share.

In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). In this
case, g = 2.8% and the expected dividend per share next year = 45.98 *
17%*(1+2.8%) = $8.04 per share. Therefore, Po = 8.04/(12% - 2.8%) = $87.34 per
share.

The January effect

* is the tendency of stock prices to decline in the first few days of January
(especially the first day). But the abnormal returns on this effect have been found
to be smaller than the transaction costs required to take advantage of them,
making profit opportunities impossible.
* was originally postulated as being related to the small firm effect. Later, a tax
explanation was given which claimed that holders of poorly performing stocks
would sell at the end of the year to establish loses on those stocks, and would
then repurchase them or other stocks after the New Year.
* is the tendency of stock prices to increase in the last few days of December,
and decline in the first few days of January. This effect is especially pronounced
among small firms, although the initial explanation for the effect was tax-based.
* is the tendency of stock prices to decrease in the last few days of December,
and increase in the first few days of January. This is especially pronounced
among small firms, although the initial explanation for the effect was earnings-
based.

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 * is the tendency of stock prices to decrease in the last few days of December,
and increase in the first few days of January. This is especially pronounced
among small firms, although the initial explanation for the effect was tax-based.
That answer is correct!

Several years ago, a trading rule was proposed by Branch that predicted the
January effect. Branch claimed that investors in declining shares would tend to
sell them before the end of the year in order to establish losses (to decrease
taxes) on those stocks. Those investors would tend to repurchase those stocks,
or other stocks that looked attractive after the New Year. Studies have confirmed
the existence of a January effect wherein stock prices decline in December and
increase in January, supporting the tax theory. But the effect has also been found
to be connected with firm size, and has been found to exist in other countries
where the tax explanation would not hold. For this reason, many questions still
remain about the January effect.

The current earnings per share on a value-weighted index is $3.7. If the growth
rate in the index is expected to be 3%, its average payout ratio is 35% and the
index value is $9.3 per share, the expected return on the index is:

* 15.4%
* 16.6%
* 17.3%
* 16.9%
That answer is correct!

You should remember that the Dividend Discount Model is applicable to

individual stocks as well as stock indices. Indeed, that and estimation of the
variables involved in the DDM are the thrust of Reilly & Brown, chapter 18.

In standard notation, Po = D1/(k-g). In this case, g = 3%. The expected dividend

per share next year = $3.7 * 35%*(1+3%) = $1.33. Therefore, 9.3 = 1.33/(k-3%).
Solving for k gives k = 3% + 1.33/9.3 = 17.3%. This is the expected return on the
index.

A cyclical stock is one that:

* experiences changes in its rates of return that are greater than changes in
overall market rates of return.
* one with a rate of return that is not expected to decline during an overall market
decline, or not as much as the overall market.
* whose sales and earnings will be heavily influenced by aggregate business
activity.
* none of these answers.
* whose future earnings are likely to withstand an economic downturn.
That answer is correct!

In terms of the CAPM, these are stocks with high betas.

A firm follows the simple growth model and can invest $1000 every year into new
projects which have a rate of return of 17%. Each project generates a constant
4
stream of earnings year after year. The firm's stock has a required rate of return
of 13%. If the firm is founded today, the firm value equals ________.

* $3,165
* $2,440
* $2,675
* $1,895
That answer is correct!

You should be careful in solving such a problem.

Suppose the firm invests $1,000 today in a project. This first project generates a
constant stream of perpetuity with an annual payment of $1,000 * 0.17 = $170. The
present value of this stream is 170/0.13 = $1,307.6. The NPV of the project is then
$1,307.6 - $1,000 = $307.6. Since the firm does this every year, it has a perpetuity
of $307.6 (the NPVs of projects 2 and on, at the time the projects are started). The
present value of these NPVs is $307.6/0.13 = $2,367. Thus, the total value of the
firm is $2,367 + $307.6 (first project) = $2,675.

Contrarians interpret a low cash ratio in mutual funds at market highs as:

* a bearish signal.
* a bullish signal.
* none of these answers.
* a hold signal.
That answer is correct!

According to the contrarians, most market participants make wrong investment

decisions as the market approaches the peak or trough in a cycle.

One category of market participants they consider is mutual funds. The cash ratio
of mutual funds is the fraction of total assets that mutual funds maintain in the
form of cash. A high ratio (around 12-13%) at a market low is considered by
contrarians as a signal that the funds are bearish and a low ratio (7-8%) at a
market high is interpreted as an indication that the funds are bullish. The
Contrarians then take exactly the opposite position.

Studies have tended to indicate that investors who attempted to trade following
insiders' patterns have

* not earned excess returns.

* earned excess returns.
* earned very high excess returns.
* earned below-average returns.
That answer is correct!

Although some studies have pointed to the possibility of earning excess returns
by trading with insiders based on announced insider transactions, more have
found that no excess returns are possible once transactions costs are factored
in.

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Mermen, Inc., a manufacturer of male swimwear, has a return on equity of about
7.2%. It typically pays out about 33% of its earnings as dividends. The firm's
stock has a covariance with the market of 0.045. The market has an expected
return of 12.9% and a standard deviation of 19.4%. The prevailing risk-free rate is
4.9% and Mermen's stock return has a standard deviation of 23%. Most analysts
in the market are of the opinion that Mermen's EPS next year is likely to be
around $9.2 per share. Given these data, Mermen's share price should be about:

* $38.94
* $37.22
* $41.62
* $29.28
That answer is incorrect.
Correct answer:
$37.22

The CAPM expected rate of return on the stock is equal to the risk-free rate plus
beta times the market premium. The beta of the stock equals 0.045/(0.194 * 0.23) =
1.01. So the expected return on Mermen's stock is 4.9% + 1.01*(12.9 - 4.9)% =
12.98%.
The Dividend Discount Model implies that Mermen's share price is given by Po =
D1/(k-g), using standard notation. We have D1 = 0.33 * 9.2 = $3.036. The dividend
growth rate is given by g = ROE*(1-dividend payout ratio) = 7.2% * 0.67 = 4.824%.
The price of the stock then equals 3.036/(12.98% - 4.824%) = $37.22.