Equity Valuation【 Reading 35】Sample purchase, suppliers, one, 2012, company

bapswarrior

Laura’s Chocolates, is a maker of nut-based toffees. The company holds shares in one of its suppliers, and wants to know what the holding period return was last year.

January 1 (purchase date)	$40
December 31	$45
Dividend paid (December 31)	$5
Cost of equity	11%
Cost of debt	8%
Debt : equity	1:3

What is the holding period return (ignore taxes)?

A) 12.50%.

B) 25.00%.

C) 22.50%.

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bapswarrior

To determine the present value of an investment based on a future estimate of the investment’s value, an analyst should use the:

A) discount rate.

B) required return.

C) internal rate of return.

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The discount rate is the rate used to find the present value of an investment.

bapswarrior

In an efficient market, a mutual fund’s required return is the same as the:

A) internal rate of return.

B) holding period return.

C) net asset value return.

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The internal rate of return (IRR) is the rate that equates the value of the discounted cash flows to the current price of the security. In an efficient market, where securities are properly priced, the IRR and required return are the same.

bapswarrior

Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will:

A) both increase the size of the risk premium.

B) both decrease the size of the risk premium.

C) have offsetting effects.

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Switching from a geometric mean to an arithmetic mean will increase the mean equity return. All else being equal, that will increase the estimated risk premium. When the yield curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity risk premium estimate will be larger when short-term bond rates are used.

bapswarrior

An analyst attempting to derive the equity risk premium for a stock starting from the required return for that stock would find which of the following statistics least useful?

A) The stock’s beta.

B) Historical 10-year Treasury bond rates.

C) The stock’s estimated return.

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The required return for a stock is equal to the risk-free return plus beta times the equity risk premium. An analyst starting from the required return would need beta and a risk-free rate. Historical 10-year T-bond rates can be used as an estimate of the risk-free rate. Since the analyst is starting with the required return, estimated returns are not needed.

bapswarrior

The equity risk premium is the difference between:

A) the estimated equity return and the risk-free return.

B) estimated equity returns and estimated bond returns.

C) the required equity return and the risk-free return.

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The equity risk premium reflects the return in excess of the risk-free rate that investors require for holding stocks. It is derived by subtracting the risk-free return from the required return.