16. a. Using a financial calculator the price of the zero coupon bond ($1000 face value) selling at a yield to maturity of 8% is $374.84 and that of the coupon bond is $774.84.
  At a YTM of 9% the price of the zero coupon bond is $333.28 and that of the coupon bond is $691.79.
  Zero coupon bond    Actual % loss  =  333.28 – 374.84374.84   =  –.1109, an 11.09% loss
  The percentage loss predicted by the duration-with-convexity rule is:
  Predicted % loss =  [( –11.81)  ?.01  +  0.5 ? 150.3 ??(0.01)2]     =  –.1106, an 11.06% loss
  Coupon bond    Actual % loss = 691.79 – 774.84774.84   =  –.1072, a 10.72% loss
  The percentage error predicted by the duration-with-convexity rule is:
  Predicted % loss =  [( –11.79)  ??.01  +  0.5 ??231.2 ??(0.01)2]
     =  –.1063, a 10.63% loss
 b. Now assume yield to maturity falls to 7%.  The price of the zero increases to $422.04, and the price of the coupon bond increases to $875.91.
  Zero coupon bond
  Actual % gain  =  422.04 – 374.84374.84   =  .1259, a 12.59% gain
  The percentage gain predicted by the duration-with-convexity rule is:
  Predicted % gain   =  [( –11.81)  ??(–.01)  +  0.5 ??150.3 ??(0.01)2 ]
     =  .1256, an 12.56% gain
  Coupon bond
  Actual % gain  = 875.91 – 774.84774.84   =  .1304, a 13.04% gain
  The percentage gain predicted by the duration-with-convexity rule is:
  Predicted % gain   =  [ (–11.79)  ??(–.01)  +  0.5 ??231.2 ??(0.01)2]
     =  .1295, a 12.95% gain
 c. The 6% coupon bond -- which has higher convexity -- outperforms the zero regardless of whether rates rise or fall.  This can be seen to be a general property by noting from the duration-with-convexity formula that the duration effect on the two bonds due to any change in rates will be equal (since their durations are equal), but the convexity effect, which is always positive, will always favor the higher convexity bond.  Thus, if the yields on the bonds always change by equal amounts, as we have assumed in this example, the higher convexity bond will always outperform a lower convexity bond with equal duration and initial yield to maturity.
 d. This situation cannot persist.  No one will be willing to buy the lower convexity bond if it always underperforms the other bond.  Its price will fall and its yield to maturity will rise.  Thus, the lower convexity bond will sell at a higher initial yield to maturity.  That higher yield is compensation for lower convexity.  If rates change by only a little, the higher yield-lower convexity bond will do better; if rates change by a lot, the lower yield-higher convexity bond will do better.
 17. a. 4.     b.  4.    c.  4 .    d.  2.
 18. a. The two risks are price risk and reinvestment rate risk.  The former refers to bond price volatility as interest rates fluctuate, the latter to uncertainty in the rate at which coupon income can be reinvested.
 b.  Immunization means structuring a bond portfolio so that the value of the portfolio (with proceeds reinvested) will reach a given target level regardless of future changes in interest rates.  This is accomplished by matching both the values and durations of the assets and liabilities of the plan.  This may be viewed as a low risk bond management strategy.
 c.  Duration matching is superior to maturity matching because bonds of equal duration -- not maturity -- are equally sensitive to interest rate fluctuations.
 d.  Simply match the face value and maturity of the zero to the cash flow of the obligation.  Zeros are ideal because they pose no issue of reinvestment rate risk.
 e. Contingent immunization allows for active bond management unless and until the surplus funding in the account is eliminated because of investment losses, at which point an immunization strategy is implemented.  Contingent immunization allows for the possibility of above-market returns if the active management is successful.
19. The economic climate is one of impending interest rate increases.  Hence, we will want to shorten portfolio duration.
 a.  Choose the short maturity (2001) bond.
 b.  The Arizona bond likely has lower duration.  Coupons are about equal, but the Arizona yield is higher.
 c. Choose the 15 3/8 coupon bond.  Maturities are about equal, but its coupon is much higher, resulting in lower duration.
 d.  The duration of the Shell bond will be lower if the effect of the higher yield to maturity and earlier start of sinking fund redemption dominates its slightly lower coupon rate.
 e.  The floating rate bond has a duration that approximates the adjustment period, which is only 6 months.
20. a.  This swap would have been made if the investor anticipated a decline long-term interest rates and an increase in long-term bond prices.  The deeper discount, lower coupon 6 3/8% bond would provide more opportunity for capital gains, greater call protection, and greater protection against declining reinvestment rates at a cost of only a modest drop in yield.
 b.  This swap was probably done by an investor who believed the 24 basis point spread in yield between the two bonds was too narrow, and if it widened to a more normal level, either a capital gain would be experienced on the Treasury note or a capital loss would be avoided on the Phone bond, or both.  It could also have been done by an investor anticipating a decline in interest rates but who also wanted to maintain high current coupon income and have the better call protection of the Treasury note.  The Treasury note would have unlimited potential for price appreciation in contrast to the Phone bond which would be restricted by its call price.  Furthermore, if intermediate-term interest rates instead were to rise, the price decline of the higher quality, higher coupon Treasury note would likely be “cushioned” and the reinvestment return from the higher coupons would likely be greater.
 c.  This swap would have been made if the investor were bearish on the bond market.  The zero coupon note would be extremely vulnerable to an increase in interest rates since the yield to maturity, determined by the discount at the time of purchase, is locked in.  This is in contrast to the floating rate note where interest is adjusted by formula each six months to reflect the current return available on six-month U.S. Treasury bills.  The funds received in interest income on the floating rate notes could be used at a later time to purchase long-term bonds at more attractive yields.
 d.  These two bonds are similar in most respects other than quality and yield.  An investor who believed the yield spread between Government and Al bonds was too narrow would have made the swap either to take a capital gain on the Government bond or avoid a capital loss on the Al bond.  The increase in call protection after the swap would not be a factor except under the most bullish interest rate scenarios.  The swap does, however, extend maturity another 8 years and yield to maturity sacrifice is 169 basis points.
 e.  The principal differences between these two bonds are the convertible feature of the Z mart bond and the yield and coupon advantage and longer maturity of the Lucky Ducks debentures.  The swap would have been made if the investor believed some combination of the following: First, that the appreciation potential of the Z mart convertible, based primarily on the intrinsic value of Z mart common stock, was no longer as attractive as it had been.  Second, that the yields on long-term bonds were at a cyclical high, causing bond portfolio managers who could take A2-risk bonds to reach for high yields and long maturities either to lock them in or take a capital gain when rates subsequently declined.  Third, while waiting for rates to decline, the investor will enjoy an increase in coupon income.  Basically, the investor is swapping an equity-equivalent for a long- term corporate bond.
21. a. A manager who believes that the level of interest rates will change should engage in a rate anticipation swap, lengthening duration if rates are expected to fall, and shortening if rates are expected to rise.
 b. A change in yield spreads across sectors would call for an intermarket spread swap, in which the manager buys bonds in the sector for which yields are expected to fall and sells bonds in the sector for which yields are expected to rise.
 c. A belief that the yield spread on a particular instrument will change calls for a substitution swap in which that security is sold if its relative yield is expected to rise or is bought if  its yield is expected to fall compared to other similar bonds.
22. Choose the longer-duration bond to benefit from a rate decrease.
 a. The Aaa-rated bond will have the lower yield to maturity and the longer duration.
 b. The lower-coupon bond will have the longer duration and more de facto call protection.
 c. Choose the lower coupon bond for its longer duration.
23. You should buy the 3-year bond because it will offer a 9% holding-period return over the next year, which is greater than the return on either of the other bonds.
 Maturity:    1 year  2 years   3 years
 YTM at beginning of year            7%            8%        9%
 Beginning of year prices  $1009.35 $1000.00 $974.69
 Prices at year end (at 9% YTM)  $1000.00 $  990.83 $982.41
 Capital gain    –$      9.35 –$      9.17 $    7.72
 Coupon       $    80.00 $    80.00 $  80.00
 1-year total $ return   $    70.65 $    70.83 $  87.72
 1-year total rate of return           7%      7.08%         9%
 The 3-year bond provides the greatest holding period return.
24. The minimum terminal value that the manager is willing to accept is determined by the requirement for a 3% annual return on the  initial investment.  Therefore, the floor equals $1 million ?? (1.03)5 = $1.16 million.  Three years after the initial investment, only two years remain until the horizon date, and the interest rate has risen to 8%.  Therefore, at this time, the manager needs a portfolio worth $1.16 million/(1.08)2 = $.994 million to be assured that the target value can be attained.  This is the trigger point.
25. The answer depends on the nature of the long-term assets which the corporation is holding.  If those assets produce a return which varies with short-term interest rates then an interest-rate swap would not be appropriate. If, however, the long-term assets are fixed-rate financial assets like fixed-rate mortgages then a swap might be risk-reducing. In such a case the corporation would swap its floating-rate bond liability for a fixed-rate long-term liability.
26. The speculator who believes interest rates will fall will want to pay the floating rate and receive the fixed rate.  The investor will benefit if the short-term reference rate does in fact fall, resulting in an increase in the net cash flow from the swap.
27. a. In an interest rate swap, one firm exchanges or "swaps" a fixed payment for another payment that is tied to the level of interest rates.  One party in the swap agreement must pay  a fixed interest rate on the notional principal of the swap.  The other party  pays the floating interest rate (typically LIBOR) on the same notional principal.  For example, in a swap with a fixed rate of 8% and notional principal of $100 million, the net cash payment for the firm that pays the fixed and receives the floating rate would be (LIBOR – .08) ? $100 million.  Therefore, if LIBOR exceeds 8%, the firm receives money; if it is less than 8%, the firm pays money.
 b. There are several applications of interest rate swaps.  For example, a portfolio manager who is holding a portfolio of long-term bonds, but is worried that interest rates might increase, causing a capital loss on the portfolio, can enter a swap to pay a fixed rate and receive a floating rate, thereby converting the holdings into a synthetic floating rate portfolio.  Or, a pension fund manager might identify some money market securities that are paying excellent yields compared to other comparable-risk short-term securities.  However, the manager might believe that such short-term assets are inappropriate for the portfolio.  The fund can hold these securities and enter a swap in which it receives a fixed rate and pays a floating rate.  It thus captures the benefit of the advantageous relative yields on these securities, but still establishes a portfolio with interest-rate risk characteristics more like those of long-term bonds.
28. The firm should enter a swap in which it pays a 7% fixed rate and receives LIBOR on $10 million of notional principal.  Its total payments will be as follows:
 Interest payments on bond (LIBOR + .01)  ???$10 million par value
 Net cash flow from swap  (.07 – LIBOR)  ??$10 million notional principal
TOTAL   .08 ??$10 million
 The interest rate on the synthetic fixed-rate loan is 8%.
29. The maturity of the 30-year bond will fall to 25 years, and its yield is forecast to be 8%.  Therefore, the price forecast for the bond is $893.25  [n = 25; i = 8; FV = 1000;  PMT = 70].  At a 6% interest rate, the five coupon payments will accumulate to $394.60 after 5 years.  Therefore, total proceeds will be $394.60 + $893.25 = $1,287.85.  The 5-year return is therefore 1,287.85/867.42 = 1.485.  This is a 48.5% 5-year return, or 8.22% annually.
 The maturity of the 20-year bond will fall to 15 years, and its yield is forecast to be 7.5%.  Therefore, the price forecast for the bond is $911.73  [n = 15; i = 7.5; FV = 1000;  PMT = 65.  At a 6% interest rate, the five coupon payments will accumulate to $366.41 after 5 years.  Therefore, total proceeds will be $366.41 + $911.73 = $1,278.14.  The 5-year return is therefore 1,278.14/879.50 = 1.453.  This is a 45.3% 5-year return, or 7.76% annually.  The 30-year bond offers the higher expected return.

CHAPTER 12: MACROECONOMIC AND INDUSTRY ANALYSIS
1. Expansionary (looser) monetary policy to lower interest rates would help stimulate investment and expenditures on consumer durables.  Expansionary fiscal policy – lower taxes, higher government spending, increased welfare transfers – would stimulate aggregate demand directly.
2. a. Gold Mining.  Gold traditionally is viewed as a hedge against inflation.  Expansionary monetary policy may lead to increased inflation, and thus could enhance the value of gold mining stocks.
    b. Construction.  Expansionary monetary policy will lead to lower interest rates which ought to stimulate housing demand.  The construction industry should benefit.
3. A depreciating dollar makes imported cars more expensive and American cars cheaper to foreign consumers.  This should benefit the U.S. auto industry.
4. Supply side economists believe that a reduction in income tax rates will make workers more willing to work at current or even slightly lower (gross-of-tax) wages.  Such an effect ought to mitigate cost pressures on the inflation rate.
5. a. The robotics process entails higher fixed costs and lower variable (labor) costs.  This firm therefore will perform better in a boom and worse in a recession.  For example, costs will rise less rapidly than revenue when sales volume expands during a boom.
    b. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta.
6. Deep recession:  Health care (a non-cyclical industry)
 Superheated economy: Steel production (cyclical industry)
 Healthy expansion: Housing construction (cyclical but interest-rate sensitive)
 Stagflation: Gold mining (counter-cyclical)
7. a. Oil wells:  Decline (Environmental pressures, decline in easily-developed new oil fields)
 b. Computer hardware:  Consolidation
 c. Computer software: Consolidation
 d. Genetic engineering: Start-up
 e. Railroads: Relative decline
8. a. General Autos.  Pharmaceuticals are less of a discretionary purchase than automobiles.
 b. Friendly Airlines.  Travel expenditure is more sensitive to the business cycle than movie consumption.
10. The index of consumer expectations is a useful leading economic indicator because if consumers are optimistic about the future they will be more willing to spend money, especially on consumer durables, which will increase aggregate demand and stimulate the economy.
11. Labor cost per unit is a lagging indicator because wages typically start rising only well into an economic expansion.  At the beginning of an expansion, there is considerable slack in the economy and output can expand without employers bidding up the price of inputs or the wages of employees.  By the time wages start increasing due to high demand for labor, the boom period has already progressed considerably.
12. a. Because of its very low maturity (30 days), the rate of return on the money market fund will be only slightly affected by changes in interest rates.  The fund might be a good place to "park" cash if you forecast an increase in interest rates, especially given the high liquidity of such funds.  The $5,000 can be reinvested in longer-term assets after rates increase.
 b. If you are relatively neutral on rates, the one-year CD might be a reasonable "middle-ground" choice.  It will provides a higher return than keeping your funds in the money market fund unless rates rise considerably.  On the other hand, it has far less interest rate risk (that is, a much lower duration) than the 20-year bond, and therefore less exposure to interest rate increases.   c. The long-term bond will be the best choice for an investor who wants to speculate on a decrease in rates.
13. a. Relevant data items from the table that support the conclusion that the retail auto parts industry as a whole is in the maturity phase of the industry life cycle are:
 1. The population of 18-29 year olds, a major customer base for the industry, is  gradually declining.
 2.  The number of households with the income less than $35,000, another important  consumer base, is not expanding.
 3. The number of cars 5-15 years old, an important end market, has experienced low annual growth (or actual declines in some years), so the number of units that potentially need parts is not growing.
 4. Automotive aftermarket industry retail sales have been growing slowly for  several years.
 5. Consumer expenditures on automotive parts and accessories have grown slowly for several years.
 6. Average operating margins of all retail autoparts companies have steadily declined.
 b. Relevant items of data from the table that support the conclusion that Wigwam Autoparts Heaven, Inc. (WAH) and its major competitors are in the consolidation stage of their life cycle are:   1. Sales growth of retail autoparts companies with 100 or more stores have been growing rapidly and at an increasing rate.
 2. Market share of retail autoparts stores with 100 or more stores has been  increasing but is still less than 20 percent, leaving room for much more growth.   3. Average operating margins for retail autoparts companies with 100 or more stores are high and rising.    Because of industry fragmentation (i.e., most of the market share is distributed among many companies with only a few stores), the retail autoparts industry apparently is undergoing marketing innovation and consolidation.  The industry is moving toward the “category killer” format, in which a few major companies control large market shares through proliferation of outlets.  The evidence suggests that a new “industry within an industry” is emerging in the form of “category killer” large chain-store company.  This industry subgroup is in its consolidation stage (i.e., rapid growth with its high operating profit margins and emerging market leaders) despite the fact that the industry is in the maturity stage of its life cycle.
14. a. The concept of an industrial life cycle refers to the tendency of most industries to go through various stages of growth.  The rate of growth, the competitive environment, profit margins and pricing strategies tend to shift as an industry moves from one stage to the next although it is usually difficult to pinpoint exactly when one stage has ended and the next begun.     The initial start-up stage is characterized by perceptions of a large potential market and by a high optimism for potential profits.  In this stage, however, there is usually a high rate of failure.  In the second stage, often called rapid growth or consolidation, growth is high and accelerating, the markets are broadening, unit costs are declining and quality is improving.  In this stage, industry leaders begin to emerge.  The third stage, usually called mature growth, is characterized by decelerating growth caused by such things as maturing markets and/or competitive inroads by other products.  Finally, an industry reaches a stage of full maturity in which sales slow or even decline.
  Product pricing, profitability and industry competitive structure often vary by phase.  Thus, for example, the first phase usually encompasses high product prices, high costs (R&D, marketing, etc.)  and a (temporary) monopolistic industry structure.  In phase two (rapid expansion), new entrants begin to appear and costs fall rapidly due to the learning curve.  Prices generally don’t fall as rapidly, however, allowing profit margins to increase.  In phase three (mature growth), growth begins to slow as the product or service begins to saturate the market, and margins are eroded by significant price reductions.  In the final stage, industry cumulative production is so high that production costs have stopped declining, profit margins are thin (assuming competition exists), and the fate of the industry depends on the extent of replacement demand and the existence of substitute products/services.
 b. The passenger car business in the United States has probably entered the final stage in the industrial life cycle because normalized growth is quite low.  The information processing business, on the other hand, is undoubtedly earlier in the cycle.  Depending on whether or not growth is still accelerating or not, it is either in the second or third stage.
 c. Cars:  in the final phases of the life cycle, demand tends to be price sensitive.  Thus, Universal can’t raise prices without losing volume.  Moreover, given the industry’s maturity, cost structures are likely to be similar across all competitors, and any price cuts can be matched immediately.  Thus, Universal’s car business is boxed in: Product pricing is determined by the market, and the company is a “price-taker.”
  Idata:  Idata should have much more pricing flexibility given its earlier phase in the industrial life cycle.  Demand is growing faster than supply, and, depending on the presence and/or actions of an industry leader, Idata may price high to maximize current profits and generate cash for product development or price low in an effort to gain market share.
15. a. A basic premise of the business cycle approach to investing is that stock prices anticipate fluctuations in the business cycle.  For example, there is evidence that stock prices tend to move about six months ahead of the economy.  In fact, stock prices are a leading indicator for the economy.
  Over the course of a business cycle this approach to investing would work roughly as follows.  As the top of a business cycle is perceived to be approaching, stocks purchased should not be vulnerable to a recession.  When a downturn is perceived to be at hand, stock holdings should be lightened with proceeds invested in fixed-income securities.  Once the recession has matured to some extent, and interest rates fall, bond prices will rise.  As it’s perceived the recession is about to end, profits should be taken in the bonds and reinvested in stocks, particularly those in cyclical industries with a high beta.
  Abnormal returns generally will only be earned if these asset allocation switches are timed better than those of other investors.  Switches made after the turning points may not lead to excess returns.
 b. Based on the business cycle approach to investment timing, the ideal time to invest in a cyclical stock like a passenger car company would be just before the end of a recession.  If the recovery is aleady underway, Adam’s recommendation would be too late.  The equities market generally anticipates the changes in the economic cycle.  Therefore, since the “recovery is underway,” the price of Universal Auto should already reflect the anticipated improvements in the economy.
16. a.   Expected profit = Sales – fixed costs – variable costs
     = $120,000 – $30,000 – (1/3) ? $120,000 = $50,000
 b. DOL = 1 +  fixed costsprofits   =  1 + $30,000$50,000   =  1.6
 c. If sales are only $108,000, profits will fall to   $108,000 – $30,000 – (1/3) ??$108,000 = $42,000
  which is a decline of 16% from the forecasted value.
 d. The decrease in profits is 16%, which equals DOL times the 10% drop in sales.
 e. Profits must drop more than 100% for earnings to turn negative.  For profits to fall 100%, sales must fall by 100%/DOL = 100%/1.6 = 62.5%.  Therefore, revenues would be only 37.5% of the original forecast.  At this level, sales will be .375 ? $120,000 = $45,000.
 f. If sales are $45,000, profits will be:    $45,000 – $30,000 – (1/3) ? $45,000 = $0
17. The expiration of its patent means that General Weedkiller will soon face considerably greater competition from its competitors.  We would expect prices and profit margins to fall, and total industry sales to increase somewhat as prices decline.  The industry will probably enter the consolidation stage in which producers are forced to compete more extensively on the basis of price.
18. a. (4)      b. (3)    c. (3)      d. (2)      e. (4)      f.  (3)       g. (1)

CHAPTER 13: EQUITY VALUATION
1. (a) P = 2.10/.11 = 19.09
2. (c)
3. a. k  =  D1/P0 + g       .16  =  2/50 + g      g  =  .12
 b. P0  =  D1/(k – g)  =  2/(.16 – .05)  =  18.18
  The price falls in response to the more pessimistic dividend forecast.  The forecast for current earnings, however, is unchanged.  Therefore, the P/E ratio must fall.  The lower P/E ratio is evidence of the diminished optimism concerning the firm's growth prospects.
4. a. False. Higher beta means that the risk of the firm is higher and the discount rate applied to value cash flows is higher.  For any expected path of earnings and cash flows the present value of the cash flows, and therefore, the price of the firm will be lower when risk is higher.  Thus the ratio of price to earnings will be lower.
 b.  True.  Higher ROE means more valuable growth opportunities.
 c. Uncertain.  The answer will depend on a comparison of the expected rate of return on reinvested earnings versus the market capitalization rate.  If the expected rate of return on the firm's projects is higher than the market capitalization rate, then P/E will increase as the plowback ratio increases.
5. a. g  =  ROE  ? ? b  =  20%  ?  .30  =  6%
  D1  =  $2(1 – b)  =  $2(1 – .30)  =  $1.40
  P0  =  D1/(k – g)  =  $1.40/(.12 – .06)  =  $23.33
  P/E  =  23.33/2  =  11.67
 b. PVGO  =  P0  –  EPS0k   =  23.33 – 2.00.12   =  $6.67
 c. g  =  ROE  ?  b  =  20%  ?  .20  =  4%
  D1  =  $2(1 – b)  =  $2(1 – .20)  =  $1.60
  P0  =  D1/(k – g)  =  $1.60/(.12 – .04)  =  $20
  P/E  =  20/2  =  10
 PVGO  =  P0  –  EPS0k   =  20 –  2.00.12    =  $3.33
6. a. g  =  ROE  ? ? b  =  16%  ?  .5  =  8%
  D1 = $2(1 – b) = $2.00  ? ?(1 – .5)  =  $1.00
  P0 = D1/(k – g) = $1/(.12 – .08)  =  $25
 b. P3 = P0(1 + g)3 = $24(1.08)3  =  $31.49
7.  a. E(r)  =  k  =  D1P0  + g  =  .6020  + .08  =  .11  =  11%
 b. The model assumes that the dividend growth rate is forever constant.  Therefore, the model cannot be applied to firms that currently do not pay dividends.  Second, the model is inappropriate when g > k (which presumably cannot persist indefinitely).  Third, the model cannot handle firms with variable dividend growth paths.
 c.  One can use either P/E multiples or market-to-book multiples exhibited by other firms in the same industry.
8.  a.  This director is confused.  In the context of the constant growth model that P0 = D1/(k – g), it is true that price is higher when dividends are higher holding everything else including dividend growth constant.  But everything else will not be constant.  If the firm raises the dividend payout rate, the growth rate g will fall, and stock price will not necessarily rise.   In fact if ROE > k, price will fall.
 b.  An increase in dividend payout will reduce the sustainable growth rate as less funds are reinvested in the firm.  The sustainable growth rate is ROE ??plowback, which will fall as plowback ratio falls.  The increased dividend payout rate will reduce the growth rate of book value for the same reason -- less funds are reinvested in the firm.
9.  a. k = 6 + 1.25(14 – 6) = 16%   g = 6%     D1 = E0 (1 + g) (1 – b) = 3(1.06) (1/3) = 1.06
  P0 =  D1k – g   =   1.06.16 – .06   =  10.60
  b. Leading P0/E1  =  10.60/3.18  = 3.33    Trailing P0/E0  =  10.60/3.00  = 3.53
   c. PVGO = P0  –  EPS0k    =  10.60 –  3.16   =  – 8.15
  The low P/E ratios and negative PVGO are due to a poor ROE, 9%, that is less than the market capitalization rate, 16%.
 d. Now, you revise b to 1/3, g to 1/3 ? .09 = .03, and D1 to E0 ? 1.03 ? 2/3 = 2.06.  Thus, V0 = 2.06/(.16 – .03) = $15.85.  V0 increases because the firm pays out more earnings instead of reinvesting them at a poor ROE.  This information is not yet known to the rest of the market.
10. Because ? = 1.0, k = market return, 15%.
 Therefore 15%  =  D1/P0 + g  =  4% + g    g = 11%
11. FI Corporation   a. g = 5%; D1 = $8; k = 10%
  P0 = D1k – g  =   $8.10 – .05   =  $160
  b.  The dividend payout ratio is 8/12 = 2/3, so the payout ratio is b = 1/3. The implied value of ROE on future investments is found by solving: g = b ? ROE with g = 5% and b = 1/3.  ROE = 15%.
  c.  The price assuming ROE = k is just EPS/k.  P0 = $12/.10 = $120.  Therefore, the market is paying $40 per share ($160 – $120) for growth opportunities.
12.  Three different valuation approaches for U.S. Tobacco Co.:
  a.  Balance sheet approaches: All of the asset-related per share measures fall below the recent market price, and the stock therefore is not attractive on this basis:
  Recent Price  $54.00
  Book Value Per Share    12.10
  Liquidation Value Per Share      9.10
  Replacement Costs of Assets Per Share    19.50
 b.  Constant growth DDM approach: V0 = Dl/(k – g) = $2.10/(.13 – .10) = $70
  Thus intrinsic value exceeds market price, and the stock is attractive on this basis.
 c.  Earnings multiplier approach: If we apply the P/E multiplier of the S&P 500 to U.S. Tobacco’s estimated EPS we get 23.2  ?  $4.80 = $111.36. This exceeds UST’s market price.  (Equivalently, UST's P/E ratio is only 11.3, which is considerably less than that of the market.)  If you believe that there is no reason for such a big disparity in P/E multiples, you might conclude that the stock is underpriced by the market.
13.  High-Flyer stock.
 a.  k = rf + ? (kM – rf) = .10 + 1.5(.15 – .10)  =  .10 + .075 = .175      g = .05.
 Therefore,  P0 =  D1k – g   =   $2.50.175 – .05   =   $2.50.125   =  $20
14.  a. k = 4% + 1.15 ? (10% – 4%) = 10.9%
 b. Using Emmas's short term growth projections of 25%, we obtain a two-stage DDM value as follows:
      P0  =   D11 + k     +   D2(1 + k)2    +   D3(1 + k)3    +   D4 + D5/(k – g)(1 + k)4
   =   .2871.109     +   .3591.1092     +    .4491.1093        +    .562 + .702/(.109 – .093)1.1094
   =  .259 +  .292  + .329  +  29.378  =   30.258
 c. With these new assumptions, Disney stock has an intrinsic value below its market price of $37.75.  This analysis indicates a sell recommendation.  Even though Disney's 5-year growth rate increases so does its beta and risk premium.  The intrinsic value falls.
15. a. It is true that NewSoft sells at higher multiples of earnings and book value than Capital Corp.  But this difference may be justified by NewSoft's higher expected growth rate of earnings and dividends.  NewSoft is in a growing market with abundant profit and growth opportunities.  Capital Corp is in a mature industry with fewer growth prospects.  Both the price-to-earnings and price-to-book ratios will reflect the prospect of growth opportunities, implying that the ratios for these firms ratios do not necessarily imply mispricing.
 b. The most important weakness of the constant-growth dividend discount model in this application is that it assumes forever constant growth rate of dividends.  While dividends may be on a steady growth path for Capital Corp, which is a more mature firm, that is far less likely to be a realistic assumption for NewSoft.
 c. NewSoft should be valued using a multi-stage DDM, which allows for rapid growth in the early years, but that recognizes that growth ultimately must slow to a more sustainable rate.
16.           Stock
   A B
 Market capitalization rate, k 10% 10%
 Expected return on equity, ROE 14% 12%
 Estimated earnings per share, E1 $2.00  $1.65
 Estimated dividends per share, D1 $1.00  $1.00
 Current market price per share, P0 $27 $25
   a. Dividend payout ratio, 1 – b .50 .606
 b. Growth rate, g = ROE ? b 7% 4.728%
 c. Intrinsic value, V0 $33.33 $18.97
 d. Stock A is the one you would invest in since its intrinsic value exceeds its price. You might want to sell short stock B.
17. Tennant Company
 D0 = $.96 E0 = $1.85 ROE = 1.85/13.07 = .142
 Dividend payout = .96/1.85 = .519
 Plowback ratio = b = .481
 g = b ? ROE = .481 ? .142 = .068 = 6.8% per year.
 k = 7% + 5% = 12% per year
 a. V0 =   D1k – g  =   .96 ? 1.068.12 – .068    = $19.72
 b. If ROE = 20% and b = .65 then g = 13% per year, which is greater than k. Whenever g > k, the constant growth rate DDM is meaningless since it gives a negative value for the value of the stock. You would therefore need to try a multistage DDM.
18. Nucor Corporation     Stock Price (Dec. 30, 1997)  $53.00
 1998 Estimated Earnings  $ 4.25   1998 Estimated Book Value  $25.00
 Indicated Dividend  $ 0.40   Beta  1.10   Risk-Free Return  7.0%   High Grade Corporate Bond Yield   9.0%
 Risk Premium -- Stocks over Bonds   5.0%
 a. The expected return on the stock market is the bond yield plus the risk premium of stocks over bonds: E(rM)  =  9% + 5%  =  14%
 b.  First we must calculate ROE in order to find g.  ROE is the estimated EPS divided by estimated book value:
  ROE  =  4.25/25  =  .17  =  17%
  Dividend payout  =  .40/4.25  =  .094
  b  =  1 – .094  =  .906
  g  =  b ? ROE  =  .906 ? 17%  =  15.4% per year
  Implied total return   =  Dividend yield + g
     =  .40/53 + .154  =  .0075 + .154
     =  .162 or 16.2% per year
 c.  Required return =  rf + ? [E(rM) – rf]  =  7% + 1.1(14% – 7%)
     =  14.7% per year
 d.  Nucor’s implied total return exceeds the required return using the CAPM. This suggests that its stock is undervalued, and it is an attractive investment.
 19.  Nogro Corporation
 a. P0  =  $10, El  =  $2, b  =  .5, ROE  =  .2
  k  =  D1/P0 + g     D1  =   $1     g  =  b * ROE  =   .10    Therefore, k  =  $1/$10 + .10  =  .10 + .10  =  .20 or 20%
 b.  Since k = ROE, the NPV of future investment opportunities is zero:
  PVGO  =  P0  – EPS0k   =  10 – 10  =  0
 c.  Since k = ROE, the stock price would be unaffected by cutting the dividend and investing the additional earnings.
  Again, this should have no impact on the stock’s price since the NPV of the investments would be zero.
20.   Xyrong Corporation
 a. k  =  8% + 1.2(15% – 8%)  =  16.4%
   g  =  b  * ROE  =  .6 ? 20%  =  12%
  V0 = D0(1 + g)k – g  = $4 ? 1.12.164 – .12  = $101.82
 b. P1 = V1 = V0(1 + g)  =   $114.04    E(r) = D1 + P1 – P0P0   =  $4.48 + $114.04 – $100$100   =  .1852  =  18.52%

CHAPTER 14: FINANCIAL STATEMENT ANALYSIS
1.  ROA = ROS * ATO. The only way that Crusty Pie can have an ROS higher than the industry average and an ROA equal to the industry average is for its ATO to be lower than the industry average.
2.  ABC’s asset turnover must be above the industry average.
3.  ROE = (1 – tax rate)[ROA + (ROA ? Interest rate)Debt/Equity]
 ROEA > ROEB    Firms A and B have the same ROA.  Assuming the same tax rate, they must have different interest rates and/or debt ratios.
4.  (c) Old plant and equipment is likely to have a low net book value, making the ratio of sales to net fixed assets higher.
5. The current ratio will increase. The equal reduction in current assets and current liabilities will have a larger proportionate impact on current liabilities, and therefore the ratio of current assets to current liabilities will rise.
 Turnover will rise.  Sales should remain unaffected, but assets are lower.
6. (d).  Lower dividend payouts will result in higher retained earnings and higher growth.
7. ROE = Net profitsequity    = 5.5% ? 2 ? 1/.6 = 18.3%.
8. Par value   20,000 ? $20 =  $   400,000
 Additional paid in capital      5,000,000
 Addition to RE during year           70,000
 Book value of equity     $5,470,000    Book value per share = 5470,000/20,000 = $273.50
9.  (2) (The numerator in (c) equals the total return to all security holders, so the ratio equals return on total assets.)
10. a.   Palomba Pizza Stores  Statement of Cash Flows
For Year Ended December 31,2001
 Cash Flows from Operating Activities
  Cash Collections from Customer  $250,000
  Cash Payments to Suppliers     (85,000)
  Cash Payments for Salaries     (45,000)
  Cash Payments for Interest     (10,000)
  Net Cash Provided by Operating Activities  $110,000
 Cash Flows from Investing Activities
  Sale of Equipment       38,000
  Purchase of Equipment     (30,000)
  Purchase of Land      (14,000)
  Net Cash Used by Investing Activities     (6,000)
 Cash Flows from Financing Activities
  Retirement of Common Stock   (25,000)
  Payment of Dividends     (35,000)
  Net Cash Used by Financing Activities     (60,000)
  Net Increase in Cash        44,000
  Cash at Beginning of Year     50,000
  Cash at End of Year     $94,000
b.  The cash flow from operations (CFO) focuses on measuring the cash flow generated by operations and not on measuring profitability.  If used as a measure of performance, CFO is less subject to distortion than the net income figure.  Analysts use the CFO as check on quality of earnings.  The CFO then becomes a check on the reported net earnings figure but not as a substitute for net earnings.  Companies with high net income but low CFO may be using income recognition techniques that are suspect.  The ability of a firm to generate cash from operations on a consistent basis is one indication of the financial health of the firm.  For most firms, CFO is the “life blood” of the firm.  Analysts search for trends in CFO to indicate future cash conditions and the potential for cash flow troubles.
 Cash flow from investing activities (CFI) is an indication of how the firm is investing its excess cash.  The analyst must consider the ability of the firm to continue to grow and expand activities and CFI is a good indication of the attitude of management in this area.  Analysis of this component of total cash flow indicates the type of capital expenditures being made by management to either expand or maintain productive activities.  CFI is also an indicator of the firm’s financial flexibility and ability to generate sufficient cash to respond to unanticipated needs and opportunities.  A decreasing CFI may be a sign of a slowdown in growth of the firm.
 Cash flow from financing (CFF) presents the feasibility of financing, the sources of financing, and an indication of the types of sources management supports.  Continued debt financing may signal a future cash flow problem.  The dependency of a firm on external sources of financing (either borrowing or equity financing) may present troubles in the future such as debt servicing and maintaining dividend policy.  Analysts also use CFF as an indication of the quality of earnings.  It offers insights into the financial habits of management and potential future policies.
11.  Seattle Manufacturing Corp.
 a. ROA  =  EBIT Assets  =   Net income before tax + interest expenseAverage assets
     =   64.8 + 19.8.5(544.2 + 628)    = .144 or 14.4%
 b. EPS  =   Net income – preferred dividendsNumber of shares of common stock outstanding
   Preferred dividends = .08 ? $25 ? 600,000 shares.  Therefore,
  EPS =    $54.4 million – $1.2 million.5(2.68 million + 3 million) shares   = $18.73
  c. Acid test ratio =  Cash + commercial paper + receivablesCurrent liabilities
     = $6.6 + 15 + 93.2$224.4   = .51
 d. Interest coverage ratio   =    EBIT Interest expense   =    $64.8 + $19.8$19.8    =   4.3
 e. Receivables collection period =   Average receivablesSales      365   =   .5(77 + 93.2)1207.6   365  =  25.7 days
 f. Leverage ratio  =   Average assetsAverage common equity
  Common equity(1997) = $30 + 27 + 58.8 = $115.8 million
  Common equity(1996) = $26.8 + 26.4 + 51 = $104.2 million
  Leverage ratio   =   .5(544.2 + 628).5(104.2 + 115.8)   = 5.33?
12. Chicago Refrigerator Co.
 a. Quick Ratio = Cash + receivablesCurrent liabilities   =   $325 + $3599$3945   =  .99
 b.  ROA    =   EBITAssets  =   Net income before tax + interest expenseAverage assets
     = $2259 + 78.5($8058 + 4792)    =  .364 or 36.4%
 c. ROE   =   Net income – preferred dividendsAverage common equity
     Preferred dividends = .1 ? $25 ? 18,000 = $45,000
     Common equity in 1997 = $829 + 575 + 1,949 = $3,353 million
     Common equity in 1996 = $550 + 450 + 1,368 = $2,368 million
  ROE  =  Net income – preferred dividendsAverage common equity   =  $1265 – 45.5(3353 + 2368)   =  .426 = 42.6%
 d. Earnings per share =  $1265 – $45.5(829 + 550)   =  $1.77 per share
 e. Profit margin   =  EBITSales   =  $2259 + 78$12065   =  .194  =  19.4%
 f. Times interest earned =   EBITInterest expense   =   $2259 + 78$78   =  30
 g. Inventory turnover  =  Cost of goods soldAverage inventory    =  $8048.5(1415 + 2423)   =  4.19
 h. Leverage ratio  =   Average assetsAverage common equity    =   .5(4792 + 8058).5(2368 + 3353)   =  2.2
13. Atlas Corporation
 a. Acid test ratio =   Cash + commercial paper + receivablesCurrent liabilities
     =   $3.3 + 46.6112.2   =  .44
 b. Inventory turnover =  Cost of goods soldAverage inventory   =  $475.6.5(125.6 + 143)   =  3.54
 c.  EPS   =   Net income – preferred dividendsNumber of shares of common stock outstanding
     =  $27.2.5(1.5 + 1.34)    =  $19.15
 d. Interest coverage  =  EBIT Interest expense    =  $32.4 + $9.9$9.9    =   4.27
 e. Leverage ratio =   Average assetsAverage common equity    =   .5(264.6 + 306.5).5(52.1 + 57.9)   =  5.19
14. a      15. a     16. b
17. a. [FIFO during deflation means higher-historical-cost goods are “taken out of inventory.”  So accounting income is lower and assets are lower.
18. c    19. c     20. b

CHAPTER 15: TECHNICAL  ANALYSIS
1.  The resistance level is established by the history of the market reaching but failing to rise above a given price range.  The support level is established by the history of the market reaching but failing to fall below a given price range.
2. Trin  = Volume declining/Number decliningVolume advancing/Number advancing
   = 310,620/1,264548,016/1,781   =  .799     This trin ratio, which is below 1.0, would be taken as a bullish signal.
3. Breadth:
 Day   Advances   Declines     Net Adv   Cumulative Breadth
  Monday 1,403   1,615    ?242  ?242
  Tuesday 1,781 1,264    517      +275
 Breadth is postive and increasing.  This is a bullish signal (although no one would actually use a two-day measure as in this example).
5. The confidence index rises from 8/9 = .889 to 9/10 = .90.  This would indicate slightly higher confidence.  But the real reason for the increase in the index is the expectation of higher inflation, not higher confidence about the economy.
6. September 17: market is down from previous days, trading volume is higher; thus, signal is bearish.
 October 15: market is up, trading volume is high; signal is bullish.
 November 5: market is down, trading volume is high; signal is bearish.
 January 5: market is up, trading volume is down slightly from previous days, but still high; signal is bullish.
7. At the beginning of the period, the price of Computers, Inc. divided by the industry index was 0.39; by the end of the period, the ratio had increased to 0.50.  As the ratio increased over the period, Computers, Inc. appeared to be outperforming other firms in its industry.  The overall trend, therefore, indicates relative strength, although some fluctuation existed during the period, with the ratio falling to a low point of 0.33.
8. Five day moving averages:
Days 1 – 5:   (19.625 + 20 + 20.5 + 22 + 21.125) / 5 = 20.65.
Days 2 – 6 = 21.125   etc.
Days 10 – 14 =  23.15    ???Buy signal (day 10 price > moving average).
Days 11 – 15 = 22.50
Days 18 – 22 = 19.275  ??????Sell signal (day 18 price < moving average).
10. This pattern shows a lack of breadth.  Even though the index is up, more stocks fell than rose, which indicates a “lack of broad-based support” for the rise in the index.
11.  The signal is bearish as cumulative breadth is negative; however, the negative number is declining in magnitude, indicative of improvement.  Perhaps the worst of the bear market has passed.
12. Trin  = Volume declining/Number decliningVol advancing/Num advancing = 330 million/906240 million/704  =  1.07
 This is a slightly bearish statistic, avg volume in declining issues a bit greater than average volume in advancing issues.
13. Confidence Index  =  Yield on top rated corporate bondsYield on intermediate grade corporate bonds
 This year: Confidence Index = 8% / 9%  =  0.89.   Last year: Confidence Index = 9% / 10% = 0.90.
 Thus, the confidence index is decreasing.