1. Cache Creek Manufacturing Company is expected to pay a dividend of $4.20 per share in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The stock is trading on the market today at $84. The risk-free rate of return is 2%, and the expected return on the market portfolio is 14%.
(a) Suppose the price today reflects the company’s intrinsic value determined by the constant-growth DDM. What is the expected rate of return on this stock?
(b) Now the company publicly announces its short-term investment plan, which requires the company keep the dividend steady at $4.20 per share for the three upcoming years. After that, dividends are expected to grow at the rate of 9% per year. Using the expected rate of return calculated in (a) as the market capitalization rate, determine the new intrinsic value of the company that reflects this new piece of information.
(c) How do you think the market price of the stock will change in response to this new information? How does the change in price relate to your view on market efficiency?
(d) After doing extensive research, you find out there are two independent economic factors, F1 and F2, that can affect stock returns. You observe two well-diversified portfolios P1 and P2. Given the data below, calculate risk premia, γF1 and γF2, on these two economic factors. For P1 βF1=1.2 βF2=1.5 E(rP)=25%. For P2, βF1=1.0 βF2=0.85 E(rP)=15%
(e) Using historical data, you analyze that the Cache Creek Manufacturing Company has βF1 of 1.85 and βF2 of 0.97. According to APT, is the company overvalued or undervalued?
(f) In fact, the stock of the Cache Creek Manufacturing Company has been trading in a narrow range around $84 per share for months. You believe it is going to stay in that range for the next 3 months despite of the new information. The price of a 3-month at-the-money put option is $3, and an at-the-money call with the same expiration date sells for $4. Suppose you write a strap and the stock price winds up to be the intrinsic value you calculated in part (b) at contract expiration. What is your net profit/loss on the strap?