Assignment Overview: For this assignment, Questions 1, 3, and 5 are computational in nature. Questions 2 and 4 are conceptual questions. So make sure to thoroughly review the required background readings and make sure you understand the material at a conceptual level and also understand the steps involved in the computations.
For computational questions, you are not required to use Excel, but make sure to show all of your steps as part of your Word document. If you decide to use Excel, attach your spreadsheet in addition to a Word document with your answers. For conceptual questions, make sure to thoroughly explain the reasoning behind your answer and to use references from the required background reading.
Assignment: Submit your answers to the following questions in a Word document that includes both your computational steps in Questions 1, 3, and 5, and thoroughly explains your reasoning for Questions 2 and 4:
1. Using a dividend discount model, what is the value of a stock that pays an annual dividend of $5 that is not expected to grow and the discount rate is 10%? What will be the value of the stock if the dividend is expected to grow 5% per year?
2. Explain whether each of the following is systematic or unsystematic risk using references to the required background readings:
a. There is a large recession.
b. It is discovered that a company lied about its earnings and it is not nearly as profitable as they claimed.
c. The CEO of a successful company gets arrested for some serious crimes, and the company has trouble finding a good replacement.
3. Use the CAPM to calculate the following:
a. The expected return of a stock with a beta of 2, and risk-free rate of 1%, and a market return of 7%.
b. The beta if the expected return of the stock is 8%, the risk-free rate is 2%, and the market rate of return is 6%.
4. Do you think the following companies would have a high, low, or average beta? Explain your answer using references from the background readings and your knowledge of CAPM and beta:
a. The ACME Umbrella company's stock goes up a lot when it rains, but goes down when it is sunny. Nothing else but the weather seems to impact ACME's stock price.
b. Vultures, Inc., specializes in buying assets of bankrupt companies at a discount. Vultures' stock price seems to go up whenever other companies are doing poorly and going bankrupt, but goes down when other companies are doing well and they have few bankrupt companies to prey on.
c. Unoriginal, Inc., can never decide what products they want to focus on so they make many different products in several different industries. They also invest much of their profits into 100 or so other companies that are listed on the stock exchange.
5. Suppose the Tweedledee Company has an average return of 18%, and the Tweedledum Company has an average return of 10%. They both have a standard deviation of return of 10%, but Tweedledee has a beta of 2 and Tweedledum has a beta of 1. The risk-free rate is 1%. What are the Treynor and Sharpe Ratios of these two companies? What do these ratios tell you about the relative risk and return of these two companies?