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How Can We Learn from Finance

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Problem Set 6 Professor Orly Sade Question 1: Use the constant dividend growth model to suggest which of the following three stocks you should invest in. Explain your answer. Firm X Firm Y Firm Z Dividend per Share (d1) Current Share Price K Return on Equity Reinvestment in Firm / Plow back (b) Question 2: Suppose that the consensus forecast of security analysts of XYZ company is that the earnings next year will be E1 = $5 per share. Suppose that the company tends to plow back 50% of its earnings and pay the rest as dividends. The Chief Financial Officer (CFO) estimates that the company’s growth rate will be 6% from now onwards. (a) If your estimate of the company’s required rate of return on its stock is 10%, what is the equilibrium price of the stock? (b) How can you find if your own 10% estimate of the stock’s required rate of return is shared by the rest of the market? (c) Now assume that the required estimate of 10% is shared by the market, what does the market price of $50.00 per share imply about the market’s estimate of the company’s growth rate? $1 $100 10% 10% 95% $10 $180 10% 10% 50% $15 $200 10% 15% 25%

Question 3 Starting date: Closing Prices on the date (Nov 5) of the submission date of Problem Set 6

Ending Date: Closing Prices, Nov 24.

Assume that you have $100,000 that you decided to invest in either 1 company or 2 companies from the 30 companies that are listed below (these are the companies that the dow index is constructed from). Your performance in problem set 10 will be evaluated according to:

(return of your portfolio minus Rf)/ Beta of the portfolio In the evaluation, we will make few simplifying assumptions: 1. The Beta of each share will be taken from Yahoo finance. 2. For simplicity you will be given a constant rate for the Rf =0. Yet the evaluation is in problem set 10 – so what do you need to do for THIS problem set? For this problem set you need to: 1. Write a short report that describes your investment strategy. Explain your choices. Remember: only 1 or 2 stocks from the list that is provided below.

2. Estimate (according to your own judgment) the probability that the adjusted return of your portfolio will be at the highest 10% of the class __________________

3. Imagine that the same exercise is done not only in our section of the course but also in all other sections that study "Foundation of Finance" this semester. If this was the case (which is not), predict (according to your own judgment) the probability that the adjusted return of your portfolio will be at the highest 10% of the students that attend all sections of the foundation of finance course __________________ 4. Imagine that instead of asking you to invest in either 1 company or 2 from the dow – I asked you to invest in 1 company or 2 from the Dax (Germany) – you do not need to pick any particular firms but rather to answer the following question according to your own judgment: Estimate (according to your own judgment) the probability that the adjusted return of your portfolio (one or 2 stocks from the Dax) will be at the highest 10% of our class___________

List of firms (from the The Dow Jones Index): http://www.djaverages.com/?go=industrial-components

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