FINA2203

Spring 2022‐23

Tutorial 10

Topic Review
• Chapter 7: Stock Valuation (cont.)
• Chapter 11 : Risk and Return in Capital Markets

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7.4 Estimating Dividends in the DDM
Estimating the Growth Rate
• Firm's internal growth comes from retaining some of the firm’s profit for
reinvestment in the firm, in turn resulting in the growth of future
earnings. It is this internal growth that matters to the present common
stockholders.

• Growth rate (g) = Retention rate × Return on new investment

where g = the growth rate of earnings and the growth rate of dividends
Retention rate = the company’s percentage of profit retained

• Dividend Payout Rate = Dividends / Earnings

Retention Rate = 1 – Dividend Payout Rate

• Growth rate (g) = (1 – Payout rate) × Return on new investment

7.4 Estimating Dividends in the DDM

Question 4
You expect KT Industries (KTI) will have earnings per share of $5 this
year and expect that they will pay out $2.50 of these earnings to
shareholders in the form of a dividend. KTI's return on new
investments is 14% and their equity cost of capital is 11%. The value
of a share of KTI's stock today is closest to ________.

A) $75.00
B) $37.50
C) $62.50
D) $25.00

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7.4 Estimating Dividends in the DDM

• Growth rate (g) = Retention rate × Return on new investment

$ .
• Growth rate (g) = 1 14% 7%
$

$ .
• P $62.5 per share
% %

Answer: C

7.6 Share Repurchases and the Total Payout Model

Share Repurchases and the Total Payout Model
• Share Repurchase is the firm uses excess cash to buy back its own stock.

• Consequences:
• The more cash the firm uses to repurchase shares, the less cash it has
available to pay dividends;
• By repurchasing shares, the firm decreases its share count, which increases its
earnings and dividends on a per‐share basis.

• Total Payout Model computes value of total payouts to all shareholders

(both in the forms of dividends and share repurchase) rather than a
single share.

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7.6 Share Repurchases and the Total Payout Model
Question 5
Aaron Inc. has 321 million shares outstanding. It expects earnings at
the end of the year to be $641 million. The firm's equity cost of
capital is 11%. Aaron pays out 50% of its earnings in total: 30% paid
out as dividends and 20% used to repurchase shares. If Aaron's
earnings are expected to grow at a constant 7% per year, what is
Aaron's share price?

A) $12.48
B) $24.96
C) $37.44
D) $49.92

7.6 Share Repurchases and the Total Payout Model

• Aaron Inc. will have total payout this year of 50% × $641 million =
$320.5 million.

• Using the constant growth perpetuity formula, we have

PV (Future total dividends and repurchases)
$ .
= = $8,012.5 million
% %

• To compute the share price, we divide $8,012.5 million by the

current number of shares outstanding.
$ , .
P = $24.96 per share

Answer: B
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11.2 Historical Risks and Returns of Stocks
Question 1
Suppose you invested $93 in the Ishares High Yield Fund (HYG) a year
ago. It paid a dividend of $0.53 today and then you sold it for $94.
What was your dividend yield and capital gains yield on the
investment?

A) 0.54%, 1.13%
B) 0.57%, 1.08%
C) 0.57%, 1.13%
D) 1.08%, 1.18%

11.2 Historical Risks and Returns of Stocks

$ .
• Dividend yield = = = 0.57%
$

• Capital gain = $94 – $93 = $1;

$
• Capital gains yield= = = 1.08%
$

Answer: B

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11.2 Historical Risks and Returns of Stocks
Use of Average Return

• Arithmetic average return  Estimate expected return for each

year in future

• Geometric return (Compound average return)  Measure

historical performance

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11.2 Historical Risks and Returns of Stocks

Question 2
Amazon.com stock prices gave a realized return of 15%, 15%, –15%,
and –15% over four successive quarters. What is the annual realized
return for Amazon.com for the year?

A) – 4.45%
B) – 7.12%
C) – 5.12%
D) 0%

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11.2 Historical Risks and Returns of Stocks

• (1 + 0.15) × (1 + 0.15) × (1 – 0.15) × (1 – 0.15) = 0.9555

• 0.9555 – 1 = – 0.0445 or – 4.45%

Answer: A

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11.2 Historical Risks and Returns of Stocks

Question 3
The geometric average annual return for a large capitalization stock
portfolio is 10% for ten years and 6% per year for the next five years.
The geometric average annual return for the entire 15 year period is
________.

A) 9.08%
B) 8.65%
C) 8.22%
D) 9.52%

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11.2 Historical Risks and Returns of Stocks

• 10% annual return for ten years = (1 + 0.1)10 = 2.5937

• 6% annual return for five years = (1 + 0.06)5 = 1.3382

• Total return (15 years) = 10% annual return for ten years × 6%
annual return for five years  2.5937 × 1.3382 = 3.4709

• Geometric average annual return = 3.47091/15 – 1 = 0.0865 = 8.65%

Answer: B

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11.2 Historical Risks and Returns of Stocks

Question 4
If returns on stock A are more volatile than the returns on stock B,
the geometric average return of stock A will be ________ the
geometric average return of stock B when their arithmetic average
returns are same.

A) same as
B) higher than
C) lower than
D) always same as

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11.2 Historical Risks and Returns of Stocks

Assume stock A are more volatile than stock B and their arithmetic
average returns are same.
Y1 Y2 SD Arithmetic Geometric
return return (Volatile) average returns average returns
Stock A +50% ‐50% 0.7071 0.5 + (‐0.5)/2 years = 0 [(1.5) x (0.5)]1/2 ‐1 = ‐13.39%
Stock B +30% ‐30% 0.4242 0.3 + (‐0.3)/2 years = 0 [(1.3) x (0.7)]1/2 ‐1 = ‐4.61%

The geometric average return of stock A is lower than stock B.

Answer: C (lower than)

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11.3 The Historical Tradeoff Between Risk and Return

Question 5
Which of the following statements is FALSE?

A) Expected return should rise proportionately with volatility.

B) Investors would not choose to hold a portfolio that is more volatile
unless they expected to earn a higher return.
C) Smaller stocks have lower volatility than larger stocks.
D) The largest stocks are typically more volatile than a portfolio of
large stocks.

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11.3 The Historical Tradeoff Between Risk and Return
• Option A is correct. Expected return should rise proportionately
with volatility.

• Option B is correct. The returns should be higher enough to

compensate the higher risk.

• Option D is correct. The largest stocks are typically more volatile

than a portfolio of large stocks.

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11.3 The Historical Tradeoff Between Risk and Return

• Option C is wrong. Smaller stocks have higher volatility than larger stocks.

Answer: C

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11.3 The Historical Tradeoff Between Risk and Return
Question 6
Consider the following average annual returns:
Investment Average Return
Small Stocks 23.7%
S&P 500 13.8%
Corporate Bonds 7.9%
Treasure Bonds 6.5%
Treasury Bills 4.5%

What is the excess return for the S&P 500?

A) 11.5%
B) 16.3%
C) 0%
D) 9.3%

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11.3 The Historical Tradeoff Between Risk and Return

• Risk premium: excess return required from an investment in a

risky asset over a risk‐free asset.

13.8% – 4.5% = 9.3% (also called risk premium)

Answer: D

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 Q&A

Thank You!

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