LI Financial Markets and Institutions

EXERCISES CLASS 4

1. Indicate whether you agree or disagree with the following statements. Explain your answers.
(a) All stocks pay dividends, as that is the only way stockholders can earn profits.
(b) Common stocks are the riskiest corporate security, followed by preferred stocks and
then bonds.
(c) A stock’s market value will be higher the higher its expected dividend stream is, all
else being equal.
(d) The constant growth model assumes that a stock’s dividend grows at a constant rate
forever.
(e) A stock’s market value will be higher the higher the investor’s required rate of return
is, all else being equal.

2. Answer the following questions as indicated.

(a) Suppose Microsoft Inc. was trading at $27.29 per share. At that time, it pays an
annual dividend of $0.32 per share, and analysts have set a 1-year target price around
$33.30 per share. What is the expected return on this stock?
(b) Huskie Motor has just paid an annual dividend of $1.00 per share. Management has
promised shareholders to increase dividends at a constant rate of 5%. If the required
return is 12%, what is the current price per share?
(c) LaserAce is selling at $22.00 per share. The most recent annual dividend paid was
$0.80. Using the constant growth model, if the market requires a return of 11%, what
is the expected dividend growth rate for LaserAcer?
(d) NewPort Holdings expects to pay an annual dividend of $1.50 per share and stock
analysts expect the dividend to grow by 7% indefinitely. If NewPort Holdings current
share price is $25, what would be the required rate of return?
(e) Gordon & Co. stock has just paid its annual dividend £1.10 per share. Analysts
believe that Gordon will maintain its historic dividend growth rate of 3%. If the
required return is 8%, what is the expected price of the stock next year?
(f) Nat Industries just went public. As a growing firm, it is not expected to pay a dividend
for the first five years. After that, investors expect the firm to pay an annual dividend
$1.00 per share with no growth. If the required return is 10%, what is the current
stock price?

Mary Dawood – University of Birmingham | Page 1

 LI Financial Markets and Institutions

3. Consider the following limit order book:

Limit buy orders Limit sell orders

Price Shares Price Shares
49.75 500 50.25 100
49.50 800 51.50 100
49.25 500 54.75 300
49.00 200 58.25 100

The last trade in the stock occurred at a price of £50.

(a) If a market buy order for 100 shares arrives, which price will it be filled at?
(b) What price will the next market buy order be filled at?
(c) If you were the dealer, you would like to increase or decrease your inventory of this
stock?

4. Consider the following information on a stock market in an economy with only three public
companies: A, B and C.

Company Shares Price, beginning of year Price, end of year

A 200 £100 £94
B 2000 £25 £30
C 20,000 £6 £12

(a) Calculate the percentage change of a price-weighted stock price index.

(b) Calculate the percentage change of a value-weighted stock price index.
(c) Suppose that the central bank, in order to increase wealth and to boost private spend-
ing, decides to lower interest rates. This makes the stock market investment relatively
more attractive. Which stock market index would be most appropriate to monitor the
effect of this policy?

Mary Dawood – University of Birmingham | Page 2

 LI Financial Markets and Institutions

5. Consider the following quotes from four dealers:

Dealer Bid Ask

A £32.30 £33.10
B £32.50 £33.00
C £32.10 £32.70
D £32.40 £32.80

(a) What is the best bid price and the best ask price?
(b) Suppose you have submitted a buy market order to your broker. What is the price at
which the trade will be executed?
(c) Suppose you have submitted a limit order to sell at £32.60. Will the trade be executed?
If yes, at what price?
(d) Suppose you have submitted a limit order to buy at £32.60. Will the trade be exe-
cuted? If yes, at what price?

Mary Dawood – University of Birmingham | Page 3