Practice problem: Final

Stock valuation
1. The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%,
and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its
earnings in dividends, and the latest earnings announced were $10 per share. Dividends were just
paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per
year on all reinvested earnings forever.

a. What is the intrinsic value of a share of Xyrong stock?

b. If the market price of a share is currently $100, and you expect the market price to be equal to
the intrinsic value 1 year from now, what is your expected 1-year holding-period return on
Xyrong stock?
Solution:
a. k = rf + β [E(rM ) – rf ] = 8% + 1.2(15% – 8%) = 16.4%
g = b  ROE = 0.6  20% = 12%
D0 (1  g ) $4 1.12
V0    $101.82
kg 0.164  0.12

b. P1 = V1 = V0(1 + g) = $101.82  1.12 = $114.04

D1  P1  P0 $4.48  $114.04  $100
E (r )    0.1852, or 18.52%
P0 $100

Immunization

4. You are managing a portfolio of $1 million. Your taryget duration is 10 years, and you can
choose from two bonds: a zero-coupon bond with maturity of 5 years, and a perpetuity, each
currently yielding 5%.

a. How much of each bond will you hold in your portfolio?

b. How will these fractions change next year if target duration is now 9 years?

a. The duration of the perpetuity is: 1.05/0.05 = 21 years

Call w the weight of the zero-coupon bond. Then
(w × 5) + [(1 – w) × 21] = 10  w = 11/16 = 0.6875
Therefore, the portfolio weights would be as follows: 11/16 invested in the zero and
5/16 in the perpetuity.
 b. Next year, the zero-coupon bond will have a duration of 4 years and the perpetuity
will still have a 21-year duration. To obtain the target duration of nine years, which is
now the duration of the obligation, we again solve for w:
(w × 4) + [(1 – w) × 21] = 9  w = 12/17 = 0.7059

So, the proportion of the portfolio invested in the zero increases to 12/17 and the proportion
invested in the perpetuity falls to 5/17.