 # Stock valuation question?

I just went through a Schweser book1 practice exam and cama away with a pretty dismal 58%. I would be grateful for any help with this particular problem. An anayst has gathered the following data about a company. . historical earnings retention rate of 60%, projected to continue in the future. . a sustainable return of equity of 10% . a beta of 1.0 . nominal RFR is 5% . Expected market return is 10% If next years EPS is \$2 per share what value would you place on the stock? A \$20 B \$22.50 C \$30.50 D \$35.45 Any guidance gratefully appreciated. ---------------------------------------------------------------------------------------------------------------- I have not encountered conditional failure rate as yet, please could someone explain how this would come into effect? A venture capital firm is considering a \$2 million investment in a firm developing health care apparatus The conditional failure rate is 20% (???) per year over a 5 year horizon with an expected payoff of \$5.5m at the end of year 5. Using disco rate of 20% the NPV of this investment is closest to… I just didn’t know where to go with that conditional failure clause…cheers.

first get growth rate. roe*retention rate = .1*.6 = .06 next get cost of equity using CAPM = .05+ [1(.1-.05)] = .1 next years div = next years EPS * payout ration so 2*.4 = .8 so .8/(.1-.06) = 20 ____________________________________________________ conditional failure I believe is just the probablility of failing (losing initial investment) in each year

For the second Q, I think the 20% is the probability of failure each year, which makes up for a probability of project success at the end of year 5 of (1-0.2)^5=0.8^5=32.768% Calculate the PV of the outcome if the project succeeds: N=5, I/Y=20, PMT=0, FV=5,500,000, CPT PV=2,210,326.65 The investment’s NPV = 2,210,326.65 * 32.768% - 2,000,000 (1-32.768%)=-620,360.16 Is this anywhere close to the answer you’re looking for?

yeah i’m curious now to. I think Map’s solution is correct. I always have trouble with these venture capital NPV things for some reason.

EPS question is definitely A \$2 x (1-RR) = \$2 x (1-.6) = \$0.8 = Div1 You have discount rate of 10. To calc growth rate, g = ROE X RR 10 x .6 = .06 0.8/(.1-.06) = \$20 The extra info is distraction info. If you weren’t given the discount rate you could use the RFR, Beta and E® to get the discount rate. It’s actually the same if you do the calculation R = RFR + Beta(E® - RFR) or R = 5% + 1(10%-5%) R = 10% I can’t answer the 2nd question as I have not gotten to alternative investments yet.

Guys, Thankyou very much for the helpful response… I have to say, things do seem more obvious, which hopefully means I am building up a basic understanding! With respect to the correct answers… For the Stock valuation one it is indeed \$20 Answer A For the NPV with the fun of probability built in, the choices were; The NPV of this investment, using a discount rate of 20% is closest to; A; -\$1,275,000 B; -\$275,000 C; \$230,000 D; \$607,500 The correct answer appears to be A -\$1,275,000 I have the answers in letter form without working, I have double checked that A is the answer supplied. I have previously encountered the soul destroying moment when I have marked an exam with answers from another test!!!..In the case I have double checked they suggest A.

probability of success = 1- 0.8^5 = 0.3277 Probability of failure = 1- 0.3277 = 0.6723 NPV incase of Success = -2,000,000 + (5,500,000 / 1.2^5) = 210,327 NPV in case of failure = -2,000,00 NPV Of investment = 0.3277 * 210,327 + 0.6723 * (-2,000,000) = 1,275,676 So the closest answer is -1,275,000

Ok, so I’ve searched the forum for the second question, and I found plenty of posts (and now I feel stupid:)) So, it seems the “errata” shows: the NPV of a successful project, is calculated as -\$2,000,000 + (5,500,000 / 1.2^5) = 210,326.65 the expected NPV would be an weighted average, calculated as: (0.32768 x 210,326.65) + (0.67232 x -2,000,000) = -\$1,275,680.17 Check this: http://www.analystforum.com/phorums/read.php?11,489192,489192#msg-489192