Reference no: EM13776404

1. Based on the following information calculate the expected return and the standard deviation for the two stocks.

State of Economy	Probability of State of Economy	Rate of Return on stock A	Rate of Return on stock B
Recession	0.10	6%	-20%
Normal	0.60	7%	13%
Boom	0.30	11%	33%

What is the expected return on stock A and stock B?

a. What is the variance and standard deviation for stock A and stock B?

b. What isof the standard deviation of an equally weighted portfolio of these two stocks if the correlation is 0.2?

2. Compare and contrast the scope and construction of the following three U.S. stock market indices:

• the Dow Jones Industrial Average (DJIA);
• the Standard and Poor 500 (S&P 500);
• the NASDAQ Composite index.

3. Identify the following conditions according to where each fits in the objective constraints-policies framework.

a. Invest 5% in bonds and 95% in stocks.

b. Do not invest more than 10% of the budget in any one security.

c. Shoot for an average rate of return of 11%.

d. Make sure there is $95,000 in cash in the account on December 31, 2015.

e. If the market is bearish, reduce the investment in stocks to 80%.

f. As of next year, we will be in a higher tax bracket.

g. Our new president believes pension plans should take no risk whatsoever with the pension fund.

h. Our acquisition plan will require large sums of cash to be available at any time.

4. Mrs. Mary Atkins, age 66, has been your firm's client for five years, since the death of her husband, Dr. Charles Atkins. Dr. Atkins had built a successful newspaper business that he sold two years before his death to Merit Enterprises, a publishing and broadcasting conglomerate, in exchange for Merit common stock. The Atkinses have no children, and their wills provide that upon their deaths the remaining assets shall be used to create a fund for the benefit of Good Samaritan Hospital, to be called the Atkins Endowment Fund.

  Good Samaritan is a 180-bed, not-for-profit hospital with an annual operating budget of $12.5 million. In the past, the hospital's operating revenues have often been sufficient to meet operating expenses and occasionally even generate a small surplus. In recent years, however, rising costs and declining occupancy rates have caused Good Samaritan to run a deficit. The operating deficit has averaged $300,000 to $400,000 annually over the last several years. Existing endowment assets (that is, excluding the Atkins's estate) of $7.5 million currently generate approximately $375,000 of annual income, up from less than $200,000 five years ago. This increased income has been the result of somewhat higher interest rates, as well as a shift in asset mix toward more bonds. To offset operating deficits, the Good Samaritan Board of Governors has determined that the endowment's current income should be increased to approximately 6% of total assets (up from 5% currently). The hospital has not received any significant additions to its endowment assets in the past five years.

Identify and describe an appropriate set of investment objectives and constraints for the Atkins Endowment Fund to be created after Mrs. Atkins's death.

5. You have been named as investment adviser to a foundation established by Dr. Walter Jones with an original contribution consisting entirely of the common stock of Jomedco, Inc. Founded by Dr. Jones, Jomedco manufactures and markets medical devices invented by the doctor and collects royalties on other patented innovations.

   All of the shares that made up the initial contribution to the foundation were sold at a public offering of Jomedco common stock, and the $5 million proceeds will be delivered to the foundation within the next week. At the same time, Mrs. Jones will receive $5 million in proceeds from the sale of her stock in Jomedco.

   Dr. Jones's purpose in establishing the Jones Foundation was to "offset the effect of inflation on medical school tuition for the maximum number of worthy students."

   You are preparing for a meeting with the foundation trustees to discuss investment policy and asset allocation.

a. Define and give examples that show the differences between an investment objective, an investment constraint, and investment policy.

b. Identify and describe an appropriate set of investment objectives and investment constraints for the Jones Foundation.

c. Based on the investment objectives and investment constraints identified in part b, prepare a comprehensive investment policy statement for the Jones Foundation to be recommended for adoption by the trustees.

6. Identify and briefly describe the three forms of the efficient market hypothesis.

7. If markets are completely efficient, discuss the appropriate role of a portfolio manager.

8. Research shows that some publicly available information such as dividend yields can be used to predict future security returns. Discuss whether this fact violates any form of the efficient market hypothesis.

9. Explain what the Efficient Market Hypothesis means? If this hypothesis is true, can an investor expect to earn consistently higher returns than the market average?

10. Suppose an analyst uses a DDM valuation model in order to arrive at his/her Buy-Sell-Hold recommendations. Would it be inconsistent of his/her to also believe in the Efficient Market Hypothesis? Explain.

11. Suppose an analyst uses a valuation model (either DDM, DCF, or AE) in order to arrive at her Buy-Sell-Hold recommendations. Would it be inconsistent of her to also believe that investor psychology explains much of the movement in stock prices (thus, for example, reading charts might be helpful)? Explain.

12. How might an investor's choice of valuation model (e.g., DDM, DCF, or AE) be influenced by the type of corporation (e.g., young, mature, high-tech, consumer staples, etc.)? That is, when might the AE valuation model be preferable to other valuation models? When would DCF?

13. In your opinion and in terms of a critique of the efficient markets hypothesis, what are two of the most important anomalies that researchers have found? Briefly explain why the anomalies present a critique of the efficient markets hypothesis. In your opinion and in terms of behavioral finance, what sort of behaviors have been identified that might lead one to reject (or, at least question) the efficient markets hypothesis?

14. Would you expect the required rate of return for a U.S. investor in U.S. common stocks to be the same as the required rate of return on Japanese common stocks? What factors would determine the required rate of return for stocks in the United States versus Japan?

15. The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $132 a year from now. If you require 12 percent on this stock, how much would you be willing to pay for it?

16. Given the expected earnings and dividend payments in question no. 14, if you expect a selling price of $110 and require an 8 percent return on this investment, how much would you pay for the BBC stock?

17. Over the long run, you expect dividends for BBC in question no. 14 to grow at 8 percent and you require 11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?

18. Based on new information regarding the popularity of basketball, you revise your growth estimate for BBC to 9 percent. What is the maximum P/E ratio you will apply to BBC, and what is the maximum price you will pay for the stock?

19. You have been reading about the Madison Computer Company (MCC), which currently retains 90 percent of its earnings ($5 a share this year). It earns an ROE of almost 30 percent.

a. Assuming a required rate of return of 14 percent, how much would you pay for MCC on the basis of the earnings multiplier model? Discuss your answer.

b. What would you pay for Madison Computer if its retention rate was 60 percent and nits ROE was 19 percent? Show your work.

20. Gentry Can Company's (GCC) latest annual dividend of $1.25 a share was paid yesterday and maintained its historic 7 percent annual rate of growth. You plan to purchase the stock today because you believe that the dividend growth rate will increase to 8 percent for the next three years and the selling price of the stock will be $40 per share at the end of that time.

a. How much should you be willing to pay for the GCC stock if you require a 12 percent return?

b. What is the maximum price you should be willing to pay for the GCC stock if you believe that the 8 percent growth rate can be maintained indefinitely and you require 12 percent return?

c. If the 8 percent rate of growth is achieved, what will the price be at the end of Year 3, assuming the conditions in Part b?