CHAPTER 18 Equity Valuation Models

CHAPTER 1
Exercise 1: On February 1, you bought 100 shares of stock in the Francesca Corporation
for $34 a share and a year later you sold it for $39 a share. During the year, you received a
cash dividend of $1.5 a share. Compute your HPR and HPY on this Francesca stock
investment.

Ending value of investment 39∗100+1.5∗100

HP R❑ = = =1.19
Beginning value of investment 34∗100
=> HP R annual=HP R1 /n =HPR
=> HPY = HP R annual−1=1.19−1=0.19

Exercise 2: At the beginning of last year, you invested $4000 in 80 shares of the Chang
corporation. During the year, Chang paid dividends of $5 per share. At the end of the year,
you sold the 80 shares for $59 a share. Compute your total HPY on these shares and
indicate how much was due to the price change and how much was due to the dividend
income.

HPY = HP R annual−1
2 years -> HP R annual=HP R1 /2
Ending value of investment 80∗59+5∗80
HPR= = =1.28
Beginning value of investment 4000
=> HP R annual=HP R1 /2 =1.13
HPY = HP R annual−1=1.13−1=0.13

Exercise 3: During the past 5 years, you owned two stocks that had the following annual
rates of return (=possible return):
Year Stock T Stock B

1 0.19 0.08

2 0.08 0.03

3 -0.12 -0.09

4 -0.03 0.02

5 0.15 0.04

a. Compute the arithmetic mean annual rate of return for each stock. Which stock is
most desirable by this measure?
AMT= ( HPY1, + HPY2+…+ HPyn)/n = (0.19 +0.08 - 0.12 - 0. 03 + 0.15 ) /5 = 0.054 =
5.4%
AMB= (0, G8 + 0,03 - 0,09 + 0,02 + 0,04.) /5 =0,016= 1.6%
=> Stock T is most desirable because it has higher AM
b. Compute the standard deviation of the annual rate of return for each stock. By this
measure, which is the preferable stock? (So sánh độ lệch chuẩn - cái nào càng nhỏ
 CHAPTER 18 Equity Valuation Models

càng tốt)

Stock T
5
1
E(R) = ∑ ❑Pi * Ri = ( 0.19+0.08−0.12−0.03+0.15)=0.054 = AMT
n =1 5
Công thức standard devi: 0.19 = Ri (rate of return/ possible return - đề cho), 0.054 = E(Ri)
(phải tính, ở đây bằng AMT/ AMB).
2 1
∂= ¿
5
= 0.013
⇒ ∂=0.115

Stock B
5
1
E(R) = ∑ ❑Pi * Ri = ( 0.08+0.03−0.09+0.02+0.04)=0.016 = AMb
n =1 5
2 1
∂= ¿
5
=
⇒ ∂=0.054
=> By this measure, B would be preferable because 0.057 < 0.115).

c. Compute the coefficient of variation (hệ số biến thiên) for each stock. By this
relative measure of risk, which stock is preferable? (Hệ số biến thiên nhỏ hơn thì
preferable hơn)

Standard deviation ∂
Coefficient = =
Expected return E(R)
∂ 0.115
C VT= = =2.13
E( R) 0.054
∂ 0.054
C V B= = =3.375
E( R) 0.016
=> T is more preferable then B (2.13 < 3.375)

d. Compute the geometric mean rate of return for each stock. Discuss the difference
between the arithmetic mean return and the geometric mean return for each stock.
Công thức:GM =[(1+ HPY 1)(1+ HPY 2)...(1+ HPYn)mũ1 /n]−1

GMt = [(1.19)∗(1.08)∗(0.88)∗(0.97)∗(1.15)mũ 1/5 ]−1=0.4757 .

GMb = [(1.08)∗(1.03)∗( 0.91)∗(0.97)∗(1.04)mũ 1/5]−1=0.4757 .

Exercise 4: You are considering acquiring shares of common stock in the Madison Beer
Corporation. Your rate of return expectations are as follows:
 CHAPTER 18 Equity Valuation Models

Possible rate of return Probability

-0.1 0.3

0.0 0.1

0.1 0.3

0.25 0.3

Compute the expected return E(Ri) on your investment in Madison Beer.

5
E(Ri) = ∑ ❑Pi * Ri = 0.3 * (-0.1) + 0.1 *0.0 +0.1 * 0.3 +0.25*0.3 = 0.075 = 7.5%
n =1

Exercise 5: Investor A considers to invest in one of 2 following common stocks.

Stock A Stock B

Probability Return (Ri) Probability Return

(Pi)

0,4 12% 0,1 -5%

0,2 16% 0,4 9%
0,4 17% 0,3 18%
0,2 20%

Determine which stock that investor A should invest in?

Stock A:
5
E(Ri) = ∑ ❑Pi * Ri = 0.4*12% + 0.2 * 16% + 0.4*17% = 14.8%
n =1

Stock B:
5
E(Ri) = ∑ ❑Pi * Ri =0.1 * (-5%) + 0,4*9% + 0.3*18%+ 0.2 * 20% = 12.5%
n =1

=> Investor should invest in stock A

Exercise 6: There are rates of return in the last 5 years of stock A

2003 2004 2005 2006 2007

5% -2% 4% 8% -1%

Determine variance and standard deviation of this stock?

Variance for historical return R=[ 5 %+(−2 %)+4 %+8 %−1 % ] / 5=2.8 %
 CHAPTER 18 Equity Valuation Models

1
=> Var = ¿
5−1
= 1.77 * 1 0−3
The standard deviation of this stock

SD = √ ❑

Exercise 7: An investor invests 100 million dong in stock A. After 1 year, there are 3
possible investment results as the following:
Probability Rate of return

Growth economy 0,3 80%

Stable economy 0,4 10%

Recession economy 0,3 -60%

a) Determine expected return of stock A?

E(R) = 0.3 * 80% + 0.4*10% + 0.3 *(-60%) = 0.1 = 10%
b) Determine variance and standard deviation of stock A?
∂2=0.3 ¿ = 0.294 = 29.4%
⇒ ∂=0.5422

Exercise 8: An investor buys stock A at price $30. It is expected that 1 year later, stock
A’s price could be as the following:
Probability 0,2 0,3 0,5

Price 32 36 27

Determine variance, standard deviation of this stock?

Price Probability = Pi HPY = Ri

32 0.2 (32-30)/30 = 6.67%

36 0.3 (36-30)/30 = 20%

27 0.5 (27-30)/30 = –10%

 CHAPTER 18 Equity Valuation Models

E(R) = 0.2*6.67% +0.3 * 20% + 0.5 * (-10%) = 2.334%

2
∂ =0.2¿ = 0.0173 = 1.73%
⇒ ∂=0.1315

Exercise 9: An investor buys 100 shares A at 30000 dong/ share. At the end of this year,
he buys more 100 shares A at 32000 dong/share. After 2 years, he sells all 200 share A at
34000 dong/ share. During these 2 years, this investor receives 2000 dong/ share per year.
Determine the average rate of return of this investor?

HPR(1) for 100 shares at 30000/share = Ending value/Beginning value =

(34000+2000x2)/30000 = 1.2667
⇒ HPRannual = HPR(1)❑1/ 2 = 1.2667❑1/ 2 = …
⇒ HPY(1) for 100 shares at 30000 dong/share = HPRannual(1) - 1 = …
HPR(2) for 100 shares at 32000/share = Ending value/Beginning value =
(32000+2000)/(32000) = 1.125
⇒ HPRannual(2) = HPR(2) = 1.125
⇒ HPY(2) = HPR(2) = 1.125
HPY (1)+ HPY (2)
Average rate of return of this investor based on AMT: 2 =…

Exercise 10. Given the following information:

Stock A
Scenario Probability Rate of Expected [Ri - E(R)] 2
∂ = Pi * [Ri
(Pi) return (Ri) return = ^2 - E(R)] ^2
E(R) = Pi *
Ri

1 0.3 0.6 0.18 0.1024 0.03072

2 0.25 0.7 0.175 0.1764 0.0441

 CHAPTER 18 Equity Valuation Models

3 0.25 -0.7 -0.175 0.9604 0.2401

4 0.2 0.5 0.1 0.0484 0.00968

=> E(R) = 0.18 + 0.175 - 0.175 + 0.1 = 0.28
Variance = 0.03072 + 0.0441+0.2401+0.00968 = 0.3246
Standard deviation = √❑0.5697
Cof = 0.5697/ 0.28 =2.034
Stock B

Scenario Probability Rate of Expected [Ri - E(R)] ∂2= Pi * [Ri

(Pi) return (Ri) return = ^2 - E(R)] ^2
E(R) = Pi *
Ri
1 0.4 0.6 0.24 0.0036 0.00144
2 0.6 0.7 0.42 0.0016 0.00096
=> E(R) = 0.24 + 0.42 = 0.66
Variance =0.00144 + 0.00096 = 0.0024
Standard deviation = √❑0.0489
Cof = 0.0489/ 0.66 = 0.0742

Stock B has higher expected return , lower standard deviation and variance , lower coefficient
of variance
=> Stock B is better than Stock A => Choose this stock

Exercise 11: Given information about VN-Index:

Trading date VN-Index

3/1/2007 1123,07

4/2/2007 1055,1

5/2/2007 935,48

6/1/2007 1077,36

7/2/2007 994,17

8/1/2007 923,14

8/31/2007 908,37

9/28/2007 1046,86

10/31/2007 1065,09

11/30/2007 972,35
 CHAPTER 18 Equity Valuation Models

12/28/2007 927,02

Determine rate of return and variance of VN-Index in this period.

DATE VN-Index HPY

3/1/2007 1123,07

4/2/2007 1055,1 =( 1055.1 - 1123.07)/1123.07 = -0.0605

5/2/2007 935,48 -0.1134

6/1/2007 1077,36 0.1517

7/2/2007 994,17 -0.0772

8/1/2007 923,14 -0.0714

8/31/2007 908,37 -0.0160

9/28/2007 1046,86 0.1525

10/31/2007 1065,09 0.0174

11/30/2007 972,35 -0.0871

12/28/2007 927,02 -0.0466

AM=
−0.0606−0.1134+ 0.1517−0.0772−0.0714−0.0160+0.1525+0.0174−0.0871−0.0466
=−0.016
10
GM= 0.25701
1
Var = ¿ = 0.00898
10−1
=> Standard deviation = 0.095

Exercise 12 : Stock X and Y have the possible returns in some scenario next year:
Scenario Probabil Possible return of X Possible return of Y
ity (%) (%)

1 0,2 -10 9

2 0,4 17 -2

3 0,4 20 6

Determine:
a) Determine expected return of stock X and Y
 CHAPTER 18 Equity Valuation Models

STOCK X

Scenari Probabilit Possible return of X (%) E(R) Variance

o y =Pi*Ri

1 0,2 -10 -2 103.968

2 0,4 17 6.8 7.056

3 0,4 20 8 20.736

Expected return = -2 + 6.8 + 8 = 12.8

STOCK Y

Scenario Probabil Possible return of Y E(R) = Pi*Ri Variance

ity (%)

1 0,2 9 1.8 6.272

2 0,4 -2 -0.8 11.664

3 0,4 6 2.4 2.704

Expected return of stock Y = 1.8 - 0.8 + 2.4 = 3.4

b) Determine variance and standard deviation of these stocks?

Variance of stock X = 103.968 +7.056+20.736 = 131.76
Standard deviation of stock X = √❑

Variance of stock Y =6.272 + 11.664 + 2.704 = 20.64

Standard deviation of stock Y = √❑
c) Determine coefficient of variation of stock X and Y?
Coe of stock X = 11.4786/12.8 = 0.896
Coe of stock Y = 4.5431 / 3.4 = 1.3362

Exercise 13: Stock X and Y have the possible returns next year:
Scenario Probability Possible Possible
return of A return of B
(%) (%)

1 0,1 -11 -5

2 0,35 15 10

3 0,55 18 16
 CHAPTER 18 Equity Valuation Models

a) Determine the expected return of stock X and Y

b) Determine variance and standard deviation of these stocks
c) Determine coefficient of variation of stock X and Y
STOCK A

Scenario Probability Possible E(Ri) Variance

return of A
(%)

1 0.1 -11 -1.1 62.75025

2 0.35 15 5.25 0.315875

3 0.55 18 9.9 8.581375

Total 14.05 71.6475

Expected return = -1.1 + 5.25 + 9.9 = 14.05
Variance = 71.6475
Standard deviation = √❑
Coe = 8.4644/14.05 = 0.6024

STOCK Y

Scenario Probability Possible E(Ri) Variance

return of B
(%)

1 0,1 -5 -0.5 28.224

2 0,35 10 3.5 1.134

3 0,55 16 8.8 9.702

Total 11.8 39.06

Expected return = -0.5 + 3.5 + 8.8 = 11.8
Variance = 39.06
Standard deviation = √❑
Coe = 6.2497/11.8 = 0.5296

CHAPTER 2

Exercise 1: A bond with face value $1000, coupon rate 10%, 20 years to maturity.
This bond pays interest semi-annually. Determine this bond’s price if the required
rate of return is 12%.
What is this bond’s price if the required rate of return is (i) 7%, (ii) 10%?
 CHAPTER 18 Equity Valuation Models

Face value: $1000, semi annually

Coupon C = 1000 x 10%/2 = $50
r=12%
Bond price
P= C x 1−¿ ¿
1000
= 50 x ¿ ¿ + ¿ ¿
Exercise 2: Stock B has 10 years to maturity, face value $1000, coupon rate 9%/ year,
pays interest annually. This bond could be bought this bond back 5 years later. The
call price is $1100. This bond is sold at yield to maturity 8.2%/ year. Determine yield
to call?
Coupon payment = 1000 x 9% = 90
r
C
Bond price = ∑ T =1
¿ ¿
¿
Market Price = 90 x 1−¿ ¿ = Bond price
1053.20 = 90 x 1−¿ ¿
⇒ YTC = …
Exercise 3: 10 years ago, Apolo Company issued bonds with some features:
- Face value $1600.
- Coupon rate 9.6%/ year
- Paying interest semi-annually.
These bonds have 5 years to maturity and are sold at 98% of face
value.
9.6 %
C = 1600 x 2 =$ 76.8(semi annually)

a) Determine yield to maturity?

Bond price = 98% x 1600 = 1568
1568 = 76.8 x 1−¿ ¿

b) Apolo company has financial trouble. It is believed that this company could afford all
interest payments. However, at maturity, this company could pay only 80% of face
value. Determine the real yield to maturity?
The actual value of face value at maturity At financial Trouble Situation
80% x 1600 = 1280
=> 1568 = 76.8 x 1−¿ ¿
real YTM= 6.64%
Exercise 4: Bond A has some features as following:
- Term to maturity: 10 years
- This bond was issued 6 years ago
- Face value is $1000
- Paying annual interest
- Coupon rate 8%
- This bond is sold at $960

a. Determine yield to maturity of this bond?

C = 1000 x 8% = 80
we have
P= C x 1−¿ ¿
⇔ 960 = 80 X 1−¿ ¿
 CHAPTER 18 Equity Valuation Models

⇔ YTM=9.24%

b. Investor B considers to buy and hold this bond for 4 years. The 2 first periodic interests
are reinvested at 9%/ year to the end of the investment period. The 2 last interests are
reinvested at 7%/ year to the end of the investment period. Determine the realized return?
Beginning Value = 960
Ending value = 80 x (1+9%)^3 + 80 x (1+9%)^2 + 80 x (1+7%)^1 + 80 x
(1+7%)^0+1000 = 1364.25
Ending value 1/ n 1364.25 1/ 4
-> Realized Return = Beginning value −1= −1=9.18 %
960

Exercise 5: Bond A has face value $1000, coupon rate 8%, pays interest semi-annually
on 15/6 and 15/12. An investor decides to buy this bond at 15/1/20XX. At this time,
this bond is quoted at the price $1008. Determine the accrued interest and the bond
price?
8%
Coupon payment = 1000 x 2 =$ 40
¿
Accrued interest = C x day ¿ 15/12¿ 15 /1 day ¿ 15/12 ¿15 /6 ¿=$ 40 x (31/182)=6.81

Exercise 6: A bond has 10 years to maturity, face value $1200, coupon rate 10%/year,
pays interest semi-annually. This bond was issued 6 years ago. The current required
rate of return is 8%/ year.
a. Determine the current bond price
C = 1200 x (10%/2) = 60
Current bond price
P = C x 1−¿ ¿

b. Determine the bond’s price 6 months later if the required rate of return is unchanged
6m later
Bond price
P= C x 1−¿ ¿ = 60 x 1−¿ ¿
c. Determine rate of return for the 6 month investment period of this investor.
1 /(1/ 2)
Ending value 1/ n 1 272.02
Rate of return = ( Beginning value ¿ −1= −1= -1.36%
1280.79

Exercise 7: Assume that you purchased an 8%, 20 year, $1000 par, semiannual
payment bond, priced at $1012.5, when it has 12 years remaining until maturity.
Compute:
a. Its promised yield to maturity
Promised YTM
C=1000x8%/2=40
Set YTM/2 = r
Bond price
P= C x 1−¿ ¿
1012.3 = 40 x 1−¿ ¿
⇔ r= 3.92% ⇔ YTM= 2 x r = 7.84%
⇒ Promised YTM = 7.84%

b. Its yield to call if the bond is callable in three years with an 8% premium
 CHAPTER 18 Equity Valuation Models

Call price = 8% x FV + FV = 1080

Set YTC/2 = y
Bond price
1012.5 = 40 x 1−¿ ¿
y = 4.93 -> YTC = 2y = 9.86%
Exercise 8: Calculate the Macaulay duration of an 8%, $1000 par bond that
matures in three years if the bond’s YTM is 10 percent and interest is paid
semiannually.
a. Calculate this bond’s modified duration
Coupon payment = 1000 x 8%/2 = 40
Bond price
1000
P= C x 1−¿ ¿ = 40 x 1−¿ ¿ + ¿ ¿
=949.24
C
D = ¿¿ ¿
=5.43 ( half year ) ⇒ 5.43 : 2 = 2,715 (year)
Bond’s modified duration: Dmod = D/(1+y) = 2.715/(1+10%) = 2.468

b. Assuming the bond’s YTM goes from 10% to 9.5%, calculate an estimate of the price
change.
YTM goes From 10% to 9.5%
-> delta Y = 9.5%-10%=-0.5%
We have price change formula
ΔP
=−D❑mod x Δ y ❑ ≤¿ Δ P=949.24 x−2.468 x(−0.5 %) = …
P

Exercise 9: A bond for the Chelle Corporation has the following

characteristics: Maturity- 12 years
Coupon-10%
Yield to maturity- 9.5%
Macaulay duration- 5.7%
Convexity- 48
Noncallable

a. Calculate the approximate price change for this bond using only its duration,
assuming its yield to maturity increased by 150 basis points. Discuss (without
calculations) the impact when you include the convexity effect.
ΔP Δy 0.015
=−5.7 x =¿
P =-D x 1+ y 1+ 0.095
To Make Result more Exact

b. Calculate the approximate price change for this bond (using only its duration) if its yield
to maturity declined by 300 basis points. Discuss (without calculations) what would
happen to your estimate of the price change if this was a callable bond.
300 basis point = 3%
Callable Bond -> use YTC -> YTC based On calling price
-> based On company
If it is callable bond -> must Used YTC to determine the bond price change
 CHAPTER 18 Equity Valuation Models

Exercise 10: Bonds of Francesca Corporation with a par value of $1000 sell for $960,
mature in five years, and have a 7% annual coupon rate paid semiannually.
Determine: Current yield ?
coupon payment 1000 x (7 % /2)
Current yield = current price = 960 = 3.65%

Yield to maturity?
1− y FV
P = C x y + ¿¿
⇔ 960 = 35 x 1−¿ ¿
⇔ y=3.99%
⇒ YTM = 2y = 7.98%

Realized yield for an investor with a three- year holding period and a reinvestment rate of
6% over the period. At the end of three years, the 7% coupon bonds with 2 years
remaining will sell to yield 7%
+Beginning value = $960
+The ending value = 35 x (1+6%)^5 + 35x(1+6%/2)^4 + 35x(1+6%/2)^3 +
35x(1+6%/2)^2 + 35x(1+6%/2)^1 + 35 + 1000 (coupon rate
= YTM) = 1226.39
⇒ realized yield
ending value 1/ n 1226.39 1 /3
= beginning value −1 = 960 −1=4.16 %

Exercise 11: Bond A has the following features:

Face value: $1800
Maturity: 15 years
Paying interest semi-annually
Coupon rate: 7%
Yield to maturity 7%
Bond A could be called 6 years later at $1120.

a. Determine yield to call if this bond is going to be bought back 6 years later
If this bond is going to be bought back 6y later
we have bond price = $1800
we set YTC=x
P= C x 1−¿ ¿
¿>1800=63 x 1−¿ ¿
mũ -12 vì t tính theo thời điểm mua đến lúc bought back . 6 years và semi =) t = -2x6 =
-12
⇒ YTC = 2x = 3.36%
b. Determine yield to call if this bond is going to be bought back after 4 years instead
of 6 years.
Exercise 12: A bond with a par value of $1000, mature in 5 years, and have a 7%
coupon rate paid annually at 31/12. The transaction date is at 31/12/20X5. This bond
is quoted at 98.1% of face value. Determine the total price that the buyer has to pay
to buy this bond?
Clean price = 98.1% x FV=98.1% x 1000 = 981
Coupon $70
 CHAPTER 18 Equity Valuation Models

No accrued interest
Dirty price = clean price = $981
Exercise 13: Bond of ABC Corporation with a par value of $1000, matures in 4 years,
and has a 6.5% coupon rate paid annually. This bond is sold at 7% yield to maturity.
Determine:
a.
Bond price
1− y FV
P = C x y + ¿ ¿ = 65 x 1−¿ ¿
Duration and modified duration
C
D = ¿¿ ¿
D=3.65

Modified duration
D 3.65
Dmod = = =3.41
1+ y 1+7 %

b. Bond price change based on duration and bond price change based on bond price
valuation method when the interest rate increases by 120 basic point

Bond price change : Δ p

120 basis point = 1.2%
IR increased by 1.2% -> Δ y =1.2 %
we have formula
ΔP Δy Δy 1.2%
=−Dx ≤¿ Δ p= px (−Dx )=983.06 x (−3.66 x )=−40.24
P 1+ y 1+ y 1+7 %
-> Bond price decrease by 40.24
c. Convexity of this bond
T
t (t+1)C
=∑ ¿¿
¿ ¿ = 15.41
t =1

d. Bond price change based on duration and convexity when the interest rate increase
by 120 basic point.
Bond price change Δ P
IR increase 1.2%
ΔP
-> Δ y =1.2 %→ P =−Dmod x Δ y +1/2 COnvexity x ¿

Δ p= px ¿
 CHAPTER 18 Equity Valuation Models

CHAPTER 3

Exercise 1. The investor is considering to invest in stock A. The most recent

dividend was 3500 VND. In the next 2 years, the dividend will be 4000 VND
and 4500 VND respectively. After that, the growth rate of dividend will be
10%/year. If the required rate of return is 15%, what should investor do if the
current price of stock is 50000 VND.

Do = 3500; D1 = 4000; D2 = 4500; g = 10%; r = 15%; Po = 50000

D3 = D2 x (1+g) = 4500 x (1+10%) = 4980

⇒ V2 = D3/(r-g) = 4980/ (15%-10%) = 99600

⇒ Intrinsic value (giá trị nội tại):

D1/(1+r)^1 + D2/(1+r)^2 + V2/(1+r)^3 = 4000/(1+15%) + 4500/(1+15%)^2 +

99600/(1+15%)^2 = 81739.13 > 50000 ⇒ BUY

Exercise 2. The most recent dividend of stock A is $1.5 per share. Stock
analysists forecast:
- In the next 4 years, the growth rate dividend will be 15%/year
- From the 5th year, the growth rate of dividend will be stable at 12%/year.
- The required rate of return is 12%/year.
a) What is the value of this stock?
Do = 1.5; g1 = 15%; g2 = 12%; r = 12%
D1 = Do x (1+g1)
D2 = Do x (1+g1)^2
D3 = Do x (1+g1)^3
D4 = Do x (1+g1)^4
D5 = D4 x (1+g2) ⇒ V4 = D5/(r-g2)
Vo = D1/(1+r) + D2/(1+r)^2 +...+ D4/(1+r)^4 + V4/(1+r)^4
b) What is the value of this stock after 3 years, 5 years and 7 years
(Assumptions: All other factors don’t change
V3 = D4/(1+r) + V4/(1+r)
V5 = D6/(r-g2)
V7 = D8/(r-g2)
Exercise 3. The most recent dividend of stock B is $2.0 per share. Stock
analysists forecast:
- In the next 3 years, the growth rate dividend will be 18%/year
- From the 4th year, the growth rate of dividend will be stable at 11%/year. -
The required rate of return is 14%/year.
a) What is the value of this stock?
Do = 2; g1 = 18%; g2 = 11%; r = 11%
D1 = Do x (1+g1)
 CHAPTER 18 Equity Valuation Models

D2 = Do x (1+g1)^2
D3 = Do x (1+g1)^3
D4 = Do x (1+g2)^4
⇒ V3 = D4/(r-g2)
⇒ Vo = D1/(1+r) +...+ D3/(1+r)^3 + V3/(1+r)^3

b) What should investor do if the current price of this stock is $52

If the current price of this stock is $52 ⇒ Intrinsic value ⇒ …
c) What is the value of this stock after 3 years, 4 years and 8 years
(Assumptions: Other factors doesn’t change.)
value of this stock after 3 years: V3 = D4/(r-g2)
value of this stock after 4 years: V4 = D5/(r-g2)
value of this stock after 8 years: V8 = D9/(r-g2)

Exercise 4. The most recent dividend of stock A was $1.34 per share. Stock
analysts forecast:
- In the next 4 years, the growth rate of dividend will be 18%/year
- In the next 6 years, the growth rate of dividend will be 14%/year
After that, the growth rate of dividend is stable at 11% to infinity.
What is the value of this stock if the required rate of return is
12.8%/year?
Do = 1.34; g1 = 18%; g2 = 14%; g3 = 11%; r = 12.8%
D1 = Do x (1+g1)
D2 = Do x (1+g1)^2
D3 = Do x (1+g1)^3
D4 = Do x (1+g1)^4
D5 = D4 x (1+g2)
D6 = D4 x (1+g2)^2
D10 = D4 x (1+g2)^6
D11 = D10 x (1+g3) ⇒ P10 = D11/(r3-g3)
P4 = D5/(1+r)^1 + D6/(1+r)^2 +...+ D10/(1+r)^6 + P10/(1+r)^6 = …

Exercise 5. The most recent dividend of stock B was $1.8 per share. Stock
analysts forecast:
- In the next 5 years, the growth rate of dividend will be 16%/year -
In the next 3 years, the growth rate of dividend will be 12%/year
After that, the growth rate of dividend is stable at 9% to infinity.
What is the value of this stock if the required rate of return is
11%/year?
Do =1.8; g1 = 16%; g2 = 12%; g3 = 9%; r = 11%
D1 = Do x (1+g1)
D2 = Do x (1+g1)^2
D3 = Do x (1+g1)^3
D4 = Do x (1+g1)^4
D5 = Do x (1+g1)^5 (cần chiết về P5)
D6 = D5 x (1+g2)
…
 CHAPTER 18 Equity Valuation Models

D8 = D5 x (1+g2)^3 (cần chiết về P8)

D9 = D8 x (1+g3) ⇒ V8 = D9/(r-g3)

V5 = D6/(1+r) + D7/(1+r)^2 + D8/(1+r)^3 + V8/(1+r)^3

V0 = D1/(1+r)^1 +... + D5/(1+r)^5 + V5/(1+r)^5.

Exercise 6. The most recent dividend of stock X was $2.1 per share. The required
rate of return is 10%/year. The growth rate of dividend will be stable at 8% to
infinity. What is the reasonable value of this stock?
Do = 2.1; r = 10%; g = 8%
D1 = Do x (1+g) ⇒ Vo = D1/r-g

Exercise 7. The most recent dividend of stock Y was $1.6 per share. The required
rate of return is 10%/year. Investor just bought this stock at $60. What is the
expected growth rate of dividend given that this growth rate will be stable to
infinity?
Do = 1.6; r = 10%; Po = 60
Po = D1/(r-g) ⇒ Po = (Do x (1+g))/(r-g) ⇒ g = …
Exercise 8. The expected dividend of stock X will be $3 per share. The required
rate of return is 12%/year. The growth rate of dividend will be stable at 10% to
infinity. What is the reasonable value of this stock?
Do =3; r = 12%; g = 10%
Vo = D1/(r-g) = (Do x (1+g))/(r-g) = …
Exercise 9. The most recent dividend of stock Y was $1.4 per share. The required
rate of return is 15%/year. The growth rate of dividend will be stable at 11% to
infinity. What is the reasonable value of this stock?
Do =1.4; r = 15%; g = 11%
Vo = D1/(r-g) = (Do x (1+g))/(r-g) = …
Exercise 10. The expected dividend of stock Z will be $2.5 per share. The required
rate of return is 16%/year. The growth rate of dividend will be stable at 12% to
infinity. What is the reasonable value of this stock?
Do =2.5; r = 16%; g = 12%
Vo = D1/(r-g) = (Do x (1+g))/(r-g) = …

CHAPTER 4

1. Why do most investors hold diversified portfolios?

It can actually improve your potential returns and stabilize your results. By owning multiple
assets that perform differently, you reduce the overall risk of your portfolio, so that no
 CHAPTER 18 Equity Valuation Models

single investment can hurt you too much

2. Why do most assets of the same type show positive covariances of returns with
each other? Would you expect positive covariances of returns between different
types of assets such as returns on Treasury bills, General Electric common stock, and
commercial real estate? Why or why not?

3. Explain the shape of the efficient frontier.

The efficient frontier is a curved line. It is because every increase in risk results in a
relatively smaller amount of returns

4. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the
efficient frontier in exact terms. Discuss the concept of dominant portfolios and show
an example of one on your graph.

5. Assume you want to run a computer program to derive the efficient frontier for
your feasible set of stocks. What information must you input to the program?

6. Why are investors’ utility curves important in portfolio theory?

7. Explain how a given investor chooses an optimal portfolio. Will this choice always
be a diversified portfolio, or could it be a single asset? Explain your answer.

8. Assume that you and a business associate develop an efficient frontier for a
set of investments. Why might the two of you select different portfolios on the
frontier?

9. Stocks K, L, and M each have the same expected return and standard deviation.
The correlation coefficients between each pair of these stocks are:
K and L correlation coefficient = +0.8
K and M correlation coefficient = +0.2
L and M correlation coefficient = –0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the
lowest standard deviation? Explain.
10. The following are the monthly rates of return for Madison Software Corp. and for
Kayleigh Electric during a six-month period.
Month Madison Software Kayleigh Electric

1 –.04 .07

2 .06 –.02

3 –.07 –.10

4 .12 .15

5 –.02 –.06

6 .05 .02
 CHAPTER 18 Equity Valuation Models

Compute the following:

a. Expected monthly rate of return [E(Ri)] for each stock
b. Standard deviation of returns for each stock
c. The covariance between the rates of return
d. The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the
computed correlation? Would these two stocks offer a good chance for diversification? Why
or why not?

a) AM Madison Software = (-0.04+0.06-0.07+0.12-0.02+0.05)/6 = 0.0167

AM Kayleigh Electric = (0.07-0.02-0.1+0.15-0.06+0.02)/6 = 0.01

b) Standard deviation =
SD Madison Software = √❑ = …
SD Kayleigh Electric = √❑
❑
c) Covariance: cov(Madison Software, Kayleigh Electric) = ∑ ❑Pi[Ra-E(Ra)][Rb-
❑
E(Rb)]
= ⅙ x (-0.04-0.0167)(0.07-0.01) + ⅙ x (0.06-0.0167)(-0.02-0.01) + … = 0.0037
cov (r 1 ,r 2) 0.0037
d) p(r1,r2) = = = …
σ1σ 2 0.06549 x 0.082865

11. Given three cases:

A) E(R1) = 0.12, E(R2) = 0.16, σ1 = 0.04, σ2 = 0.06
B) E(R1) = 0.12, E(R2) = 0.16, σ1 = 0.04, σ2 = 0.04
C) E(R1) = 0.16, E(R2) = 0.12, σ1 = 0.04, σ2 = 0.06

Without calculations, draw in what a curve with varying weights would look like if the
correlation coefficient had been +1, or if it had been –1.

12. In a two asset portfolio, the weight of one of the assets (for the minimum variance
portfolio) is given by

where 1,2 r is the correlation coefficient between the two assets. Show that

a. When the assets have equal variance, the weights must be equal.
b. When the variance of asset two is greater than that of asset 1, its weight will be less
than 0.5.
 CHAPTER 18 Equity Valuation Models

CHAPTER 4 (continued)

Exercise 13.
Considering the world economic outlook for the coming year and estimates of sales and
earning for the pharmaceutical industry, you expect the rate of return for Lauren Labs
common stock to range between -20% and +40% with the following probabilities:
Probability Possible returns

0.10 -0.20

0.15 -0.05

0.20 0.10

0.25 0.15

0.2 0.2

0.1 0.4

Compute the expected rate of return E(Ri) for Lauren Labs.

Expected return for Lauren Labs
r
E(R) = ∑ ❑Pi x Ri = 0,1x(-0,2) + 0,15x(-0,05) + 0,2x0,1 + 0,25x0,15 + 0,2x0,2 + 0,1x0,4 =
i=1
0,11

Exercise 14. Given the following market value of stocks in your portfolio and their
expected rates of return, what is the expected rate of return for your common stock
portfolio?
Stock Market value ($mil) E(Ri)

Disney 15000 0.14

Starbucks 17000 -0.04

Harley Davidson 32000 0.18

 CHAPTER 18 Equity Valuation Models

Intel 23000 0.16

Walgreens 7000 0.12

❑
⇒ Expected rate for portfolio = E(rp) = ∑ wiE( ri)
❑
15000 17000 32000 23000 7000
x 0,14+ x (−0,04 )+ x 0,18+ x 0,16+ x 0,12=¿
94000 94000 94000 94000 94000

Exercise 15. You are considering two assets with the following characteristics.
E(R1) = 0.15; E(σ1) = 0.10; w1 = 0.5
E(R2) = 0.20; E(σ2) = 0.20; w2 = 0.5
Compute the mean and standard deviation of two portfolios if r 1,2 = 0.4 and -0.6,
respectively. Plot the two portfolios on a risk- return graph and briefly explain the results.

E(R1)=0,15 ; E(σ1)=0,1 ; w1=0,5 = A

R(R2)=0,2 ; E(σ2)= 0,2 ; w2 = 0.5 = B
Mean of two portfolios = E(R1) x w1 + E(R2) x w2 = 0.15x0.5 + 0.2x0.5 = 0.175 = 17.5%
r1,2 = 0,4 = p(r1,r2) correlation coefficient
cov (1,2) −3
σ1= 0.1 ; σ2=0.2 -> r1,2= σ 1 σ 2 →cov (1,2)=8 x 10
n n
σ 2 p=∑ w i 2 σ 12 + ∑ wiwjcov ❑ij =0,52 x 0, 12+
i=1 j=1
2 2 −3
0, 5 x 0, 2 +2 x 0,5 x 0,5 x 8 x 1 0 →σp=√❑
r1,2 = -0,6 ( correlation coefficient)

Cov(1,2)= ρ 1,2xσ1σ2 = -0,6 x 0,1 x 0,2 = -0,012

Var of portfolio
n n

σ^2p = ∑
i=1
w i 2 σ 12 + ∑ wiwjcov ❑ij =
j=1
0, 52 x 0,1 2+0, 52 x 0, 22+ 2 x 0,5 x 0,5 x (−0,012)=6,5 x 1 0−3
-> Std of fort : σp = √ ❑ = 0.0806

Exercise 16. The standard deviation of Shamrock Corp. stock is 19%. The standard
deviation of Cara Co. stock is 14%. The covariance between these two stocks is 100. What
is the correlation between Shamrock and Cara stock?
(bài cho % r0 khi tính cthuc thì bỏ % và để nguyên số)
σ of Shamrock Corp. stock is 19%
σ of Cara Co. stock is 14%
cov(SC,CC) = 100
The correlation between Shamrock and Cara stock:
cov ( SC , CC )
p(SC,SS) = σSC x σCC = 0,3759
⇒ 2 rate of returns move in the same direction

Mid term test: Bond A has some features: Term to maturity is 20 years; This bond
was issued 10 years ago; Face value is $1000; Coupon rate is 7%/ year; Paying
interest annually.
1. If this bond is sold at $1100. Determine the yield to maturity.
 CHAPTER 18 Equity Valuation Models

2. If yield to maturity of this bond is 8.5%/ year. Determine:

a. Bond price?
b. Duration?
c. Convexity?
d. Bond price sensitivity when the market interest rate increases by 120 basic point? (using
(1) price valuation method; (2) duration and convexity)
e. An investor considers to buy a bond now and hold this bond for 6 years. The 3 first
periodic interests are reinvested at 7%/ year to the end of the investment period. The 3 last
interests are reinvested at 6.5%/ year to the end of the investment period. Determine
realized return?
T = 20; FV = 1000; C = 1000 x 7% = 70
1. This bond is sold at $1100
⇒ C x [1−¿ ¿ + F(1+r)❑−n - P = f
⇒ 70 x [1−¿ ¿ + 1000(1+r)❑−n - 1100 = f
r1 = 5% ⇒ f1 = …
r2 = 6% ⇒ f2 = …
f1
⇒ r = r1 + (r2-r1) f 1+¿ f 2∨¿ ¿ = … = YTM

2. YTM = 8.5%
a) P = C x [1−¿ ¿ + F(1+YTM)❑−n
⇒ P = 901.58
T 10

b) D = ∑ ❑ ¿ =∑ ❑ tx70 ¿ = 7.36 (bấm máy)

tC
t =1 ¿¿ t =1 ¿¿
T 10
t (t+1)C t (t+1)70
∑
c) C = t =1 ¿ ¿¿ ¿ ¿ ∑
= t =1 ¿ ¿¿ ¿ ¿ = 61.49

d) (1) price valuation method

The market interest rate increases by 120 basic point
⇒ Δ y = 1.2; IRnew = 8.5 + 1.2 = 9.7%
Bond price:
Pnew = 70 x 1−¿ ¿ = 831.93
Δ P 831.93−901.58
⇒ Bond price sensitivity = P = 901.58
=−7.72%

(2) duration and convexity

Bond price sensitivity:
ΔP
Δ y +1 /2 convexity x ¿
P = -Dmod x
−D
= 1+ y x❑ Δ y +1/2 convexity x ¿

−7.36
= 1+ 8.5 % x ❑1.2 % +1/2 x 61.49x ¿
= -7.69%

e) Buy a bond now ⇒ Begin value = 901.58

Bond price at year 6
 CHAPTER 18 Equity Valuation Models

1000
P = 70 x 1−¿ ¿ + ¿ ¿ = 950.87
Ending value = 70x(1+7%)^5 + 70x(1+7%)^4 + … + 70x(1+7%)^0 + 950.87 =
145.05
❑ ❑
Realized return = ¿)1/n −1 = ¿)1/ 6 −1= 8.25%