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1. Suppose you started a new company which is expected to generate a ROE of 20%. The current book value per share equals $75. The capitalization rate for the firm is 15% and you expect to grow at a constant rate of 8% forever. You are considering a strategy to increase your ROE to 30%, but expect that the focus on profitability will reduce your growth rate to 3% indefinitely. Using the Gordon Growth Model, determine the intrinsic value per share under the new strategy. Are you better off with a focus on growth or with a focus on ROE? Explain your answer.
2. Suppose you are an equity analyst following Google, and want to calculate the intrinsic value of the stock. You have determined that Google’s earnings for 2012 were $32 per share, and expect the earnings to grow at a rate of 30% in the next 5 years. During this period, Google is not expected to pay any dividends. You furthermore project that after 2017, Google will mature and will maintain a constant growth of 4% per year forever. The corresponding retention ratio would be 30%. The capitalization rate for Google is 11%. Based on this information, determine the value of a Google share. Which part of the value of the stock is due to growth? Explain your answer.
3. Suppose you are the CFO of a large pension fund in charge of interest rate management. The following table shows all payments you expect to make to retirees (in million of dollars) in the next three years:
The interest rate (at all maturities) equals 3%. What is the present value of the liabilities, and what is the McCauley duration? Suppose the fund currently holds an amount of cash equal to the present value of the liabilities. If you can buy a portfolio of 1-year zero coupon bonds and 10-year zero coupon bonds, what could you do to immunize the pension fund against changes in the interest rate and what are the benefits and drawbacks of this approach? Explain your answer.
4. Suppose you have a negative view on a certain stock and would like to sell it short. However, since you are an individual investor with a relatively small portfolio, no securities firm is willing to let you engage in short selling. But your broker agrees to let you trade options. How could you construct an investment position involving a put and a call on this stock along with either (risk free) borrowing or lending that would produce the same outcome as if you had sold the stock short? Explain your answer.
5. Suppose you are a portfolio manager considering to implement a long collar strategy on LinkedIn stock by buying 1 year put options with an exercise price of $110 and selling 1 year call options with an exercise price of $130. You own 250 shares of LinkedIn stock which currently trades at $120 per share. The risk free rate is 3% and the volatility of the returns on the stock equals 25%. You expect the stock price to either go up or down by $30 in the next year. If the price of put options with an exercise price of $110 equals $8.54, what is the net cost of the collar strategy? Also discuss what you could do to create a zero cost collar and why the collar strategy is frequently used in practice. Motivate your approach and show your calculations.