Paraphrase the answers, business and finance homework help

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these questions and the correct  answers about finance. What I need from you is paraphrase the answers and the style of the answer with keeping the same meaning of answers.

in other words, different words for the answers.

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1. Because there is inflation of 4%, the central bank intervenes and decreases the money stock by 7%. Interest rates rise by 1%, or 100 basis points. Eventually, the intervention lowers the GDP and the interest rates as well as inflation. The GDP, in fact, decreases by 1.5%, the inflation rate becomes 1%, and the interest rates drop by 1.7%, or they fall from the initial level by70 basis points (.7 %.) Divide the analysis into two areas. First, address the initial effect on the bond and the stock market. Second, discuss both, after the effects have worked themselves out as I have indicated above. Initial effect: inflation 4% increase, money supply 7% decrease, interest rates 1% increase Results: because inflation increases, interest rates will increase which will increase the cost of equity. The increase in cost of equity from the increase in interest rates will cause the price of bonds and the price of stocks to decrease. Here is the reasoning why: To determine the value of stocks, we use the equation: P = D1 / (Ke – g) Where: D1 = dividends in the next period Ke = the cost of equity g = growth rate From this equation, we can see when cost of equity increases, the denominator increases which will decrease the price of the stock. Thus, stocks will decrease in price when there is an increase in inflation and interest rates because of the increase in cost of equity. To determine the value of bonds, we use the equation: PV = FV / (1 + r)T Where: PV = present value FV = face value r = interest rates t = time As interest rates increase, the present value of the bonds decreases. This also applies to coupon bonds although the effect of interest rates on coupon bonds isn’t as strong because of the convexity of the yield curve. In conclusion, bond prices will decrease when there is an increase in inflation and interest rates because the increase in interest rates will increase the denominator and decrease the present value of the bond. After effect: GDP 1.5% decrease, inflation 3% decrease (from 4% to 1%), interest rates 1.7% decrease Results: the net effect of the intervention that causes GDP to decrease by 1.5%, inflation to decrease by 3%, and interest rates to decrease by 1.7% will be that the price of stocks and bonds increase. Here is the reasoning: Even though the decrease in GDP causes D1 and g for the equation P = D1 / (Ke – g) to decrease, the decrease in inflation and interest rates are bigger than the decrease in GDP causing the cost of equity to fall by a greater amount (D1 small decrease/ (Ke bigger increase– g smaller decrease) = P increases) which means the denominator will be smaller. The net effect of this will be an increase in stock prices. Bonds are more straight-forward since only the denominator becomes smaller. PV = FV / (1 + r)T As interest rates increase, r increases which makes the denominator smaller and the present value of the bonds increases. 2. Expound on an expansion in GDP and the effects on the stock market and bond market in two different cases. First, the economic growth does not induce inflation. Second, the economic expansion causes substantial increase in inflation. Specifically, the GDP rises by 2.5% and the inflation rises by 5.5%. In the first scenario, we have an environment where GDP raises autonomously. This will cause cash flows to increase, interest rates to increase, and cost of equity to increase. Thus, an environment where GDP raises autonomously will cause the price of stocks to increase and the price of bonds to decrease. Here is the reasoning using the same equations from question one: P = D1 / (Ke – g) Price will increase because the increase in GDP and cash flows will increase the dividends paid by and the growth of the companies. Although the cost of equity also increases, it is negated by the bigger increases in dividends and growth causing the net effect on price to be an increase. Using the equation PV = FV / (1 + r)T for bonds, we see that the increase in cost of equity will increase the denominator which will decrease the present value of the bond which will cause bond prices to decrease. In the second scenario, GDP rises by 2.5% and inflation rises by 5.5%. Because the change in inflation is bigger than the change in GDP, the effects of inflation will be stronger. Thus, the increase in inflation will cause interest rates to rise by a greater amount than the increase in GDP will cause cash flow to increase (which increases dividends and growth) and we have the net effect of prices of both bonds and stocks will decrease when inflation rises by 5.5% and GDP rises by 2.5%. This would be different if the GDP growth was greater than the inflation growth as the increase in cash flow could offset the increase in inflation causing the opposite effect for stocks. 3. How do we forecast GDP? Explain the different components of it and the determinants of those components. Gross domestic product is defined by the equation GDP = C + I + G + (X-M) where C = consumption, I = investment, G = government spending, and (X-M) = net exports. GDP measures the nation’s economic activity in monetary value of goods and services produced within a nation during a specific period of time. There are a few different ways we can attempt to forecast GDP. One way would be to use econometrics that utilizes a comprehensive sequence of formulas. While this may be the most accurate way, it is very resource expensive. Another way would be to forecast the individual components of GDP and then add them together to get total GDP. By identifying the determinants of consumption, investment, government spending, and net exports, we can forecast their future numbers to lead us to a forecasted number for GDP. The drawback to this method is that figuring out the growth of each component of GDP is not easy even if we know the determinants because we will have to make assumptions about independent variables that affect the dependent variables which will highly influence the numbers we forecast. Lastly, we have learned that the economy is positively correlated with the stock market but the economy lags behind the stock market by a period of time. Thus, we can forecast GDP by observing the performance of the stock market as well. Consumption in the GDP equation is the sum of the final purchases of goods within a nation. For example, if a toy is made in California, packaged in New Jersey, and sold in New York, only the price it sold for in New York would be added to GDP as consumption. Consumption is the largest part of GDP and is extremely important to a healthy economy. The determinants of consumption are GDP (Income), expectations of GDP, stock of consumption durables, and tax policy. Because GDP affects income, it also affects consumption. People tend to spend more when they have more income and spend less when they have less income. Thus, if GDP is growing, income will also grow which leads to increase consumption. Expectations of GDP are extremely important as well because people will spend more now if they believe GDP will grow and they will have higher income in the future. If people believe that the economy will crash and their incomes will decrease, they will save more money instead. The amount of durables an individual has will affect his or her consumption. Individuals with more durables are going to consume less in the future because they already have the items versus someone who has less durables and will need to buy items in the near future. The last determinant of consumption, tax policy, has an inverse relationship with consumption. As taxes go up, people consume less and savings rise and as taxes go down, people spend and consume more. In some places, there are taxes punishing consumption, such as in Europe, to encourage saving. Investment includes buying buildings, equipment, commercial housing, and other sorts of purchases that allow businesses to grow and produce cash in the future. As with consumption, the final sale on these items is what is included in the investment component of GDP. As a result, a house that is sold for the first time would be counted in investments but the reselling of a house would not be included. The determinants of real investment are GDP, expectations, stock of real investment, interest rates, and tax policy. GDP and expectations of GDP affect investment in the same ways as they affect consumption. When GDP or expectations of GDP rise, so does investing and when GDP or expectations of GDP fall, investment decreases. As with consumption, stock of real investment in negatively related to amount of investment. When companies have a high stock of real investments, the amount of additional investment they will do decreases since they already have the items while a company with a low stock of real investments will have to make purchases in the near future. The residential housing portion of investments is affected by interest rates. Housing and interest rates are negatively related meaning when one goes up, the other goes down. Also, much like consumption, tax policy influences investment. When tax policy in beneficial, investment will increase and when tax policy is detrimental, investment decreases. Government spending is the sum of total government expenditures on final products and services. This includes military defense, public services, construction of highways, and the wages of those employed by the government. The amount of money that the government has is determined by fiscal policy which creates a budget surplus or deficit depending on how much the government spends subtracted by the amount collected through tax policies. The only determinant of government spending is politics but this determinant has countless factors that ultimately decide how much the government spends and adds to GDP. While we often hear about political corruption, the government also tries to improve the economy by spending more when the economy is not doing well, which is known as expansionary policy, and spends less when the economy is doing well. Net exports is determined by exports minus imports. When exports are greater than imports, this number will be positive and if imports are greater than exports, this number will be negative. Net exports is determined by GDP and the competitiveness of the country. GDP determines the income of a country. As a result, if a country has higher GDP compared to the rest of the world, it will export less and import more but if the rest of the world has a higher GDP, the rest of the world will export less and import more. The competitiveness of a country relates to the relative prices of its good and services and the exchange rate. If a country’s goods and services are very cheap compared to the rest of the world, the country will have higher exports and lower imports. If a country has a weaker currency, it will also experience an increased amount of exports and a decreased amount of imports. A general statement is that countries with high GDP, strong currency, and high price levels will likely have a negative net exports balance while countries with low GDP, weak currency, and low price levels will likely have a positive net exports balance. 4. What tools have we got to foretell the values of the portions of the GDP? The tools we have to foretell the values of the portions of GDP are quarterly GDP reports, employment reports, inflation reports, consumer spending reports, income reports, and countless other economic reports that are released periodically throughout the year. These economic reports allow us to evaluate the different portions of GDP during different periods of time. As mentioned in class, although history isn’t a perfect indicator for future performance, history tends to repeat itself. Thus, looking at past economic data combined with analysis and econometrics will allow us to foretell the values of the portions of GDP. Another way to foretell values of the portions of GDP is to predict GDP first and then predict how that affects the portions of GDP. As mentioned in the previous question, GDP is a determinant of consumption, investments, and net exports. Thus, we can predict the values of these portions if we have an estimate of GDP. One way we can estimate GDP is through the relationship that a country has with its stock market. In the US, the stock market has been an accurate leading indicator for the US economy. Whenever the stock market crashed, the US economy would enter a recession soon after. Thus, if the stock market crashes and we believe GDP will fall soon after, we can conclude that consumption and investing will fall as a result. If we use leading indicators along with historical data from economic reports, we can estimate the values of the portions of GDP for the future. Using cyclical indicators is an additional way we can attempt to forecast the values of the portions of the GDP. Besides the stock market leading indicator mentioned above, there are other leading indicators such as money supply, M2, interest rate spreads, consumer expectations, manufacturing numbers, and new buildings. There are also coincidental indicators which are events that tend to happen during the troughs and peaks of the business cycle but we have yet to prove a direction correlation between these indicators and the economy. Finally, we have lagging indicators that happen after the peaks and troughs of our economy such as the labor cost for manufacturing, quality and quantities of loans, and the consumer price index for services. 5. Analyze the defense industry versus the digital mobile device industry in terms of a) Structure Ascertain that you include population, income, regulation and technology. b) Competition c) Business cycle a) The industry structure includes important characteristics of a business which are its demographics, psychographics, regulation, politics, and technology. We will focus specifically on the population, income, regulation, and technology aspects of industry structure when we compare the defense industry to the digital mobile device industry. For the defense industry, as population increases, the need for defense products increases. The reason for this is that if 1% of the population decides to go to the army and the population increases, a higher number of people will serve in the army and the army will need more defense equipment to sustain its military status. Income is an extremely important part of the defense industry as countries with higher GDP and income will be able to afford more weapons and research in developing those weapons. The reason that the US has the strongest military relates to the fact that the US has extremely high GDP allowing it to invest into this industry. Poorer countries cannot afford to buy as many weapons or invest in military research and development. Regulation is controlled by the government and heavily influences the defense industry. Because this has a lot to do with politics, the government basically decides how much a company will spend on the defense industry. Unlike consumer goods, most technology, and other industries where the consumers are normal people, the defense industry focuses more on the government since normal people usually aren’t allowed to buy items made in the defense industry. Finally, technology is what defines the success of companies in the defense industry. Every country wants to have the most technologically advanced military weapons when they go to war. Imagine a war between a country that only had knives and a country that had guns. The difference in technology is vital in the defense industry because of this reason. The structure of the digital mobile device industry shares numerous commonalities with the defense industry’s structure. As the population grows, the number of people who need digital mobile devices grows. Income is very important as well as people with higher income can afford more expenses mobile devices and to upgrade to newer devices more often. Regulation doesn’t play as important of a role on the digital mobile device industry as it does on the defense industry because consumers are making the decisions instead of the government. The government could impose high taxes to reduce the consumption of digital mobile devices but the consumer still makes the final decision unlike in the defense industry where it is strictly the government that makes the decisions. As part of the technology industry, technology is very important to digital mobile devices. We constantly see new versions of the same devices being released every year to keep up with the latest technology trends. As a result, we can see that technology is as important to the digital mobile device as it is in the defense industry. b) In order to analyze competition, we will apply Michael Porter’s Five Competitive Forces Model. Porter’s five forces that determine the long-term profitability of any industry are threats of new entrants in the industry, threats of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry among existing competitors. An industry is more desirable if it has lower levels of these five forces. Businesses succeed by effectively managing these five forces within the industry they operate in. For the defense industry, threats of new entrants in the industry are low because of high barriers to entry, threats of substitutes are also low, the bargaining power of buyers is low, the bargaining power of suppliers is low, and the rivalry among existing competitors is high. Because of the high initial cost to enter the defense industry, the barriers to entry are very high. It’s very hard to replace any weapon in the defense industry because if there is a superior weapon, the weapon will become the standard instead of competing with similar weapons. There is high rivalry amongst existing competitors because everyone wants to stay in the industry after the immense costs of entering it. The bargaining power of buyers is low because while there is competition in the industry, the choices aren’t as fast as many other industries. The bargaining power of suppliers is low because firms can easily get parts somewhere else to produce weapons since there are countless factories that could produce materials. Finally, rivalry among existing companies is high because they are fighting to stay in the industry For the digital mobile industry, threats of new entrants in the industry are low, threats of substitutes are high, the bargaining power of buyers is high, the bargaining power of suppliers is low, and the rivalry among existing competitors is high. Similar to the defense industry, start up costs are immense creating high barriers to entry. However, unlike the defense industry, the threats of substitutes are high. You can’t replace a gun with a knife but you can easily replace an Apple IPhone with a device from Samsung, LG, or any other mobile device maker. While these phones may have different small characteristics, they all have the same basic characteristics that digital mobile devices have. This leads to high bargaining power for buyers since they can easily find substitutes unlike in the defense industry. The bargaining power of suppliers is low, similar to the defense industry, because these companies can easily find someone who will manufacture their devices. Finally, the rivalry among existing competitors is very high because of the high threat of substitutes. c) The business cycle affects the cyclicality of sales for some businesses more than others. Companies that are highly influenced by the business cycle, such as luxury goods and vacation businesses, have a high bheta while industries that are not strongly influenced by the business cycle, such as consumer goods, have a low bheta. This is because when people have less income during a trough, they will cut back on things they don’t require but they won’t stop buying necessities such as food. The defense and digital mobile industries are affected differently by the business cycle. Because countries will need weapons to defend themselves no matter how the economy is doing, cyclicality doesn’t greatly affect the defense industry meaning it has a low bheta. Digital mobile devices are highly influenced by the business cycle and have a high bheta. The reason for this is that people will put off upgrading their phones and getting new devices when the economy is weak and their incomes are low since these devices aren’t as necessary unlike defense of a country. In addition, since the government is the major consumer for the defense industry and regular people are the main source of consumption for the digital mobile industry, the digital mobile industry is more susceptible to decreases in individual income. In conclusion, the defense industry is less influenced by cyclicality and has a lower bheta while the digital mobile industry is highly influenced by the business cycle and has a higher bheta. 6. We have two individuals whom we have to advise about investments. The one is a twenty three year old who has gotten a job in investment banking and is receiving 150 k annually. The other is an eighty year old woman, Ms. Brown, who has $10 million in assets, as well as owns her house mortgage free. The expenses to sustain herself is 30k for her house costs and 45 k for all other costs. She has 2 children, and she wants to pass as many of her assets to them. Assume their return objectives and their risk profiles and recommend the appropriate investments for them. The 23 year old who has an investment banking job and is receiving 150k annually will have a much different investment strategy than Ms. Brown. For the 23 year old investment banker, he or she can take more risks because of a longer time horizon and expectations of future income. More information about this individual is required such as monthly expenses, lifestyle, risk tolerance, and debt but this individual profile will typically be able to take more risk than Ms. Brown. We will assume that the 23 year old investment banker has high return objectives and a high risk tolerance. Because of this profile, I would recommend a capital appreciation strategy that involves choosing companies with high growth potential. Two industries that fit these criteria are technology and biotech. Over time, I would set up meetings with this individual to see how he or she feels about our investment strategy. If he or she wants more risk for more reward, we would invest in companies with smaller market capitalizations and if he or she wants less risk, we may consider investing in industries that are less volatile or changing our strategy to a more conservative one. Ms. Brown has $10 million in assets and owns her house mortgage free. She incurs a total yearly cost of $75k (30k from house and 45k from other costs). She is 80 years old and has 2 children. Because Ms. Brown has a shorter investment time horizon and no future expected income, her strategy will involve capital preservation where she focuses on preserving her principal while earning returns at minimal risk. This strategy would involve investing in mostly treasury bonds and certificates of deposit where the return and risk are both low. If Ms. Brown expresses that she has a higher risk tolerance than I originally expected, I would recommend a current income strategy where she would invest in investment grade bonds, preferred shares, and possibly even common shares of large-cap stocks that pay dividends. This is certainly possible given her current wealth that allows her to take some risks despite the fact that she has no future income but I would still start with the capital preservation strategy first. As a portfolio manager, it is important to know your client and their needs. Asking questions about their income, current assets, life style, debt, and financial situation is vital to gathering the information needed to effectively manage their portfolio. Once we know this information, we can set return goals and set constraints that meet the individual’s risk tolerance. From the information given in this problem, I would recommend a higher risk for higher reward capital appreciation strategy for the 23 year old because of his or her long time horizon and expected future income and a capital preservation strategy for Ms. Brown because she has a shorter time horizon and no expected future income. 7.a) Talk about two concepts to tell us about prospects of the firm. b) Talk on the drawbacks of using ROE as a performance measure. a) Two concepts that tell us about the prospects of the firm are industry life cycle and financial analysis. The industry life cycle tells us if a business is in the introduction, rapid growth, maturity, or continued maturity/stagnation/decline stage. The stage a company is in highly affects its profitability. A firm in the introduction stage will have high costs and low profit as it is developing and introducing new concepts. In the rapid growth stage, revenue is increasing at a high rate as the concepts of the industry are becoming increasingly successful. Here is where many firms try to enter the business because of high potential profitability and growth. Next, we have the mature stage where growth rate has become steady and is not increasing as fast anymore. Companies are cutting costs to maximize their operations in order to combat the decreasing profit margins from high competition. The last phase can be continued maturity, stagnation, or decline. Continued maturity is the most preferred as the slow but steady growth rate from the mature phase continues. In stagnation, the industry’s growth has stopped and in the decline phase, the industry’s prospects are not looking good. In order to avoid the stagnation and decline phases, the industry and its firms must figure out a way to continue steady growth through some sort of differentiation whether its innovation, quality, or some other method. As an investor, your investment strategy will determine what stage of a firm you want to invest in. For high-risk investors, they will invest in the introduction phase where things are speculative. An investor employing a capital appreciation strategy will invest in rapid growth firms. A more conservative investor would invest in a mature company that is stable in growth, price, and dividends. Financial analysis includes valuing firms using the dividend discount model, free cash flow to equity approach, price multiples, and other ratios to identify the prospects of a firm. By analyzing the financial statements of firms within the industry, we can come up with growth rates and valuations of firms which can then be compared with the growth rate and valuations of other firms, industries, or benchmarks. For example, if we calculate the growth rate of a technology company and we notice that the growth rate is higher than that of a competitor, we may choose to invest in the technology company with a higher growth rate because of this growth if it fits our investment strategy. If we have a value investing strategy, we would compare the price to book value ratios among firms within an industry, obtain an industry average, and then compare that average to the averages of firms and benchmarks to identify which businesses are relatively undervalued. Most financial analysts use financial analysis to evaluate and value firms and industries. Financial analysis along with evaluating the industry life cycle allows analysts to make comparisons and learn about the prospects of a firm. b) There are three major drawbacks of using return on equity (ROE) as a performance measure. The first drawback is that high ROE could be a result of high financial leverage. Using the DuPont equation, we can break down ROE into tax burden, interest burden, profit margin, asset turn over, and financial leverage. Financial leverage is defined as average total assets divided by average total equity. The higher this ratio is for a company, the more they finance their assets through debt. The higher debt a company has, the higher the risk especially in times of distress. As a result, a high ROE because of high financial leverage would not support the idea that a high ROE indicates good performance. The second reason that ROE is not the best performance measure is that the numerator of net income can be easily manipulated. Net income can be manipulated through revenue and cost recognition. For example, a company can be very aggressive in recognizing revenue which may result in early recognition of sales. There are instances where revenue has to be written off because it was recognized too early. In addition, costs can be manipulated in a similar fashion. For example, a company may capitalize its research and develop costs instead of expensing them causing lower expenses for a period of time. The accrual method of recognizing revenue and expenses causes great ambiguity in net income because of potential manipulation. In addition, net income does not reflect cash flow. Although net income and cash flow are supposed to be relatively close to each other, this is rarely ever the case. As a result, if a company has a lot of debt and does not have enough cash to pay interest expense, the firm may still go under despite having high sales if most of these sales are on credit. As a result, net income manipulation may create a false sense of company performance through high ROE. The last big drawback of ROE is the denominator, average total equity. Because the numerator is taken from the income statement and the denominator is taken from the balance sheet, ROE tries to make them comparable by taking the average total equity since the balance sheet is a snapshot at a moment in time while the income statement gives performance over a period of time. However, since the total equity is taken from the balance sheet at the beginning of the year and the end of the year, it may not accurately measure changes in equity throughout the year. For example, if a company issued new shares through a round of funding, we would not be able to tell from the balance sheet if the new equity was back loaded or front-loaded. If the new shares were issued in the beginning of December and the year end for the firm is December 31st, taking average equity by using the balance sheet numbers from the year end December 31st numbers would overestimate the amount of equity outstanding throughout the year. As a result, the average total equity in the denominator may be misleading because it’s an attempt to change a snapshot of a metric into a measurement of performance over time. 8. Define risk. Elaborate on the different cases of bheta. Explicate the 3 factors which affect it. Risk is the probability that the return on an investment will be different from the expected return. Typically, investments with greater risk will offer greater potential gains and losses in value. For instance, a micro-cap stock offers great potential gains for investors if it grows to become a large-cap stock but it runs a higher risk of going bankrupt compared to current large-cap stocks. There are two major types of risks which are unsystematic risk and systematic risk. Unsystematic risk is diversifiable risk which can be eliminated by creating a diverse portfolio. Creating a portfolio that only invests in the biotech industry creates a lot of unsystematic risk but investing in the S&P 500, which has high diversity in its holdings, would have little unsystematic risk. Systematic risk is undiversifiable risk that is unavoidable risk and comes with investing in the market in general. For example, if you invest in the S&P 500 and the whole market crashes, you are exposed to systematic risk since it cannot be diversified away. Bheta is systematic risk. The three cases of bheta are bheta = 1 where the systematic risk is equal to the market, bheta less than 1 where there is less systematic risk than the market (steady industries such as utilities and consumer goods), and bheta greater than 1 where there is more systematic risk than the market (volatile industries such as biotech and technology). The bheta of an industry is a major factor in determining the required return on capital. Riskier industries will require higher rate of return while safer industries will require lower rates of return. The three factors that affect bheta are cyclicality of sales, degree of operating leverage, and degree of financial leverage. As mentioned in part (a) of problem 7, which explained the industry life cycle, some firms and industries are more affected by the business cycle than others. Thus, their sales can be highly volatile depending on what stage of the business cycle the economy is in. Industries with low cyclicality of sales are utilities and consumer goods while industries with high cyclicality of sales are consumer discretionary and technology. Degree of operating leverage is determined by how high the fixed costs of a business or industry are. The higher the fixed costs from machinery, equipment, and other fixed assets, the higher the operating leverage. The reason this increases risk and bheta is that having higher fixed costs increases the break-even point for a business making the business riskier. Finally, we have degree of financial leverage which is determined by how much debt the company is taking on. This can be determined by looking at a firm’s debt-to-equity or debt-to-asset ratio. The higher the debt of a company, the higher potential risk a company has. When a company is in a time of distress and can’t pay the interest expenses that the debt is incurring, the company may default on the debt and go bankrupt. The lower the debt of a company is, the less likely that they will be forced to liquidate its assets to pay off its liabilities. Thus, the three factors that affect bheta or systematic risk are cyclicality of sales, degree of operating leverage, and degree of financial leverage. B. PROBLEMS 1. Cummings has EAT, depreciation expense, capital expenses, debt and debt principal payments of $9m, $2.8m, $1.3m, $40m and $1.5m respectively. Between the first and the second years, it has current assets of $11m and $13.4m and current debts of $5m and $6.1m respectively. Its unlevered bheta, D/E and t are 3, 40/60 and .4 respectively. The t bond rate is 2% and the risk premium is 8% and its sales are $90m. Cummings plows about 30% of its profits back into its business. Derive the value of Cummings, if the growth rate continues perpetually. EAT = $9m = NI, Dep = $2.8m, Cap ex = $1.3m, debt = $40m, debt principal = $1.5m, current assets at t-1 = $11m, current assets at t = $13.4m, current debt at t-1 = $5m, current debt at t = $6.1m, unleveraged beta = 3, D/E = 40/60, t = 0.4, t-bond = 2%, risk premium = 8%, sales = $90m, retention rate = 30% Equity beta = unlevered beta(1-D/E)*(1-tax rate) = 3(1-40/60)*(1-.4) =4.2% CAPM = 0.02+4.2(0.08) = 35.6% ROE = NI/total equity = 9/60 = 0.15 Growth = ROE*retention rate = 0.15*.3 = 4.5% FCFE = NI + NCC – FCInv – WCInv + net borrowings = 9m +2.8m – 1.5m – 1.3m -1.3m = $7.7m Value of Equity of Cummings = FCFE0*(1+g)/(kc-g) = $7.7(1.045)/(0.356-0.45) = $25.87m Total value of Cummings = Assets = Debt + Equity = $25.87m + $40m = $65.87m 2. We know the following about Mansur. Total assets are $1000m, E is $700m, cash is $100m and the # of shares is 1m. We estimate that the market value of equity is 2 times the book value of it. Finally, a fire sale of the firm would bring 70% of the value to the co. Compute the book value, liquidation value, replacement value and enterprise value per share of Mansur. Total assets = $1000m, equity = $700m, Cash = $100m, # of shares = 1m Book value per share = equity/# of shares = $700m/1m = $700 per share Comments: This means that we have $700 per share of equity. Liquidation value per share = [(total asset – cash)*fire sale value + cash – debt]/# of shares =[ ($1000-$100)*0.7 + $100 – 300]/1m = $430 per share Comments: We subtract cash because during liquidation, we won’t be selling $100m of cash for 70% of its value since it is already liquid. After we sell the remaining $900m in assets, we add the cash back and subtract debt to get the residual for the shareholders after the liquidation. Replacement value per share = (assets – cash – debt)/# of shares =(1000-100-300)/1m = $600 per share Comments: This is the value needed to replace the firm’s asset. We assume no inflation. Enterprise value per share = (market capitalization + debt – cash)/# of shares outstanding = ($700*2+300-100)/1m = $1600 per share Comments: since the market value is 2 times the book value, we multiply the book value by 2 to get the market capitalization. EV is a good measure of cost for when a company wants to acquire another company. In order to own 100% of another company, it will have to buy all its stocks on the market which would be its market capitalization. In addition to that, the acquiring company will have to pay off the target company’s debt but the target company will have a cash reserve to add value to the acquiring company’s cash reserve. Thus, we end up with $1600 per share for Mansur. 1. A. Estimate ABEX’s total operating income for 1990, using the data in Tables 1 through 4 Revenue = 2326.5 + 1176.23 = $3502.73 million = 4950*0.47 + 0.187*6.29 COGS = 1831.5 + 858.65 = $2690.15 million = 4950*0.37 + 6.29*0.187*(1-.27) Total operating income for 1990 (estimate) = $812.58 million = 3502.73 – 2690.15 B. Identify the additional information needed to complete a reasonable estimate for earnings per share (EPS) in 1990, and identify five primary resources from which you can obtain this information. (You should identify primary resources and not external sources for the data needed.) Additional information needed to complete a reasonable estimate for earnings per share in 1990 are SG&A, interest expense, deferred tax items, the tax rate, and dividends paid to preferred and common shareholders. Having only total operating income is not nearly enough to estimate earnings per share. For example, in 1989, net income was 23% of total operating income and in 1985, net income was only 12% of total operating income. As a result, we need the line items on the income statement between total operating income and net income to arrive at a net income to estimate earnings per share. One way we can obtain the information found on the Income Statement is through company filings such as the annual report, 10-k, and 10-Q. These reports include all the financial statements, footnotes, and management’s commentary. However, these SEC filings are from the past so we would not be able to find future period line items within these documents. Since we are looking for future line items on the income statement, we will have to figure out another approach to obtain these numbers. One way to obtain these numbers is through reading the annual report and 10-K SEC filings. Within these filings, there are notes and management’s commentary where the company’s business is discussed. Often times, there are estimates of line items found in these notes for future years. Using the numbers from these estimations may be a good way to find the additional information needed to estimate EPS. However, management tends to be very biased and may underestimate or overestimate these numbers. In addition, these are just estimates so even if management isn’t biased, their estimates could still be off. As a result, we must use digression when considering these numbers. Another way to estimate these numbers is through forecasting future line items through vertical or horizontal analysis. In vertical analysis, we would analyze ABEX’s past income sheets with all items as a percentage of sales that year. After we decide what percentage of sales the line items we need are for 1990, we can multiply that number by sales to obtain those line items. Horizontal analysis is similar except it uses a base year and looks at year over year growth of each individual line item instead. However, these are estimates which often have limited accuracy. Thus, we need to combine looking at the annual report, 10-k, 10-Q, management’s discussion, financial footnotes, and forecasts to obtain the additional information we need to calculate EPS for 1990 which is assumed to be 1 year into the future. C. Estimate and discuss the incremental changes in ABEX’S EPS based on each of the following two potential scenarios for the petrochemical division only. (i) The price of polyethylene in 1990 is 8% higher than shown in Table 4 and everything else is the same. (ii) The volume of production and sales of polyethylene is 8% higher than shown in Table 4 and everything else is the same. i) If price of polyethylene increases by 8% and everything else stays the same after total operating income on the income statement from 1989 (besides estimated # of shares outstanding) Revenue = 2512.62 + 1176.23 = 3688.85 = 1.08*4950*.470 + 0.187*6.29 COGS: = 1831.5 + 858.65 = $2690.15 = 4950*0.37 + 6.29*0.187*(1-.27) Total operating income = 998.7 = 3688.85 – 2690.15 Following items taken from 1989 income statement:  Total interest: -$444  Admin exp: -$40  Rental expense: -$22  Income from investments $4 Earnings before tax = $496.7 Assuming tax rate of 44.4% from 1989 = 0.444*496.7 = $220.5348 After tax earnings = 276.1652 = net income Preferred dividends (taken from I/S 1989): -$17 Net income available for common = 259.1652 1990 estimate of average shares outstanding: 305 million shares outstanding EPS = 259.1652/305 = $0.85 The EPS would have been $0.85 if polyethylene prices increased by 8% The original EPS before the increase for 1990 is: Revenue = 2326.5 + 1176.23 = $3502.73 million = 4950*0.47 + 0.187*6.29 COGS = 1831.5 + 858.65 = $2690.15 million = 4950*0.37 + 6.29*0.187*(1-.27) Total operating income for 1990 (estimate) = $812.58 million = 3502.73 – 2690.15 Following items taken from 1989 income statement:  Total interest: -$444  Admin exp: -$40  Rental expense: -$22  Income from investments $4 Tax rate = 44.4% Preferred dividends = -$17 Net income available for common = $155.68248 1990 estimate of average shares outstanding: 305 million shares outstanding EPS = $155.68248/305 = $0.51 We can conclude that a 8% increase in the price of polyethylene given that everything else stays as it was in 1989 will increase EPS by $0.34 derived from $0.85 – $0.51. ii) If the volume of production and sales of polyethylene is 8% higher than shown in the estimate but everything else stays the same: Revenue = 2512.62 + 1176.23 = 3688.85 COGS = 1978.02 + 858.65 = 2836.67 Total operating income = 852.18 Following items taken from 1989 income statement:  Total interest: -$444  Admin exp: -$40  Rental expense: -$22  Income from investments $4 Earnings before tax = 350.18 Assuming tax rate of 44.4% from 1989 = 0.444*350.18 = 155.47992 After tax earnings = 194.70008 = net income Preferred dividends (taken from I/S 1989): -$17 Net income available for common = 177.70008 = 194.70008-17 1990 estimate of average shares outstanding: 305 million shares outstanding EPS = 177.70008/305 = $0.58 We can conclude that a 8% increase in the production of polyethylene given that everything else stays as it was in 1989 will increase EPS by $0.07 derived from $0.58 – $0.51. 2. Dean is aware that the use of certain accounting methods can distort reported operating results. A. Using the data in Tables 1 through 4, discuss how ABEX’S use of the FIFO method of accounting for its petrochemical inventories affected that division’s operating margin during each of the following two periods. A) In a period of rising prices, FIFO will produce lower COGS than LIFO. In addition, the ending balance of inventory will be higher under FIFO when prices are rising when compared to LIFO. In a period of falling prices, FIFO will produce higher COGS than LIFO. Additionally, the ending balance of inventory will be lower under FIFO when prices are falling when compared to LIFO Year 1985 1986 1987 1988 1989 Polyethylene 0.338 0.307 0.285 0.35 0.394 cost (petrochemical) Profit % 18% 16% 20% 32% 23% i) 1985 through 1987: Average cost decreased from $0.338 in 1985 to $0.285 in 1987 because of the FIFO method which increased operating margins from 18% to 20%. This means that the older inventory was cheaper which caused lower COGS and higher profits. ii) 1987 through 1989: Average cost increased from $0.285 in 1987 to $0.394 in 1989 because of the FIFO method which increased operating margins from 20% to 23%. This means that despite higher costs, ABEX was able to sell units at a higher price to produce these higher margins. B. ABEX is considering adopting the LIFO method of accounting for its petrochemical inventories in either 1990 or 1991. Recommend an adoption date for LIFO, and justify your choice. I would not recommend that ABEX adopts LIFO for 3 main reasons which are:  Decreasing international comparability  The cost of rewriting all past financial statements  Decreased accuracy in ending inventory balances Because LIFO is only permitted under GAAP and everywhere besides the US reports under IFRS, changing from FIFO to LIFO as the method of accounting for inventory would not be a wise decision for ABEX because it reduces comparability of financial statements. In addition, when a company changes accounting methods, they must rewrite all previous financial statements which will incur additional costs for ABEX. Changing to LIFO would indicate that ABEX is incurring unnecessary costs to make its financial statements less comparable on an international level. Finally, LIFO decreases the accuracy in ending inventory balances because the inventory on the balance sheet will reflect older inventory rather than the newest replacements for old inventory. As a result, ending inventory will be overstated by LIFO when prices are falling and understated when prices are rising. Lastly, the fact that changing the inventory accounting method to LIFO from FIFO will create opportunities to manipulate earnings is not ethical behavior I would be able to support. In conclusion, I would highly discourage ABEX from changing to LIFO inventory accounting because there are more negatives than positives. 3. The operating cash flows for ABEX are graphed below. A. Using only the graph, estimate (without calculating) the correlation coefficient between petrochemical and pipeline operating cash flows from 1985 through 1989. I would estimate the correlation coefficient between petrochemical and pipeline operating cash flow from 1985 to 1989 to be between -0.5 and -1. Although there is pretty strong negative correlation between the two, it is not perfectly correlated. Every instance where the cash flow from pipelines goes up, the cash flows from petrochemicals goes down and vice-versa but the changes in cash flow are not equal. B. Using the above and the statistics provided below, analyze the impact of ABEX’s diversification into petrochemicals on the company’s total cash flows 1985 through 1989. Your analysis should consider measures of central tendency, dispersion and correlation. (approximate from graph) Year 85 Petrochemical 200 pipeline 435 Total 635 86 200 430 630 87 250 410 660 88 900 380 1280 89 800 405 1205 The impact of ABEX’s diversification into petrochemicals has increased total cash flows for ABEX from where it was in 1985. Because the total cash flow is negatively correlated, as more cash flow came from petrochemicals, less cash flow came from the pipeline portion of ABEX. This makes sense as ABEX would have to split its resources and efforts to diversify which would reduce the operating ability in the pipeline part of the business in order to grow the petrochemical part of the business. However, once ABEX was able to efficiently allocate its efforts and resources, it received a greater amount of total cash flow from the diversification into petrochemicals. We can also see that the diversification of ABEX has reduced the standard deviation of total cash flow for the company. This means that ABEX’s total cash flow from its operations will be less volatile. Additionally, ABEX’s average cash flow (mean) of $889.6m is higher than its originally cash flow of $635m showing that total cash flow has overall increased from this diversification. C. Discuss three limitations of using these data to draw conclusions about the impact of ABEX’s diversification into petrochemicals on the company’s future total cash flows. Three limitations of using these data to draw conclusions about the impact of ABEX’s diversification into petrochemicals and the company’s future total cash flow are:  High volatility of pipelines cash flows (Outliers, skewness, and kurtosis)  Mean assigns equal weights to each year’s cash flow (doesn’t account for more important years)  Regression analysis is linear As we can see from the graph and the standard deviation of 368.7 that the Petrochemicals portion of ABEX’s business has, there is high volatility in this line of business. This high volatility translates to high volatility in ABEX’s total cash flow due to outliers that may create skewness and kurtosis in the distribution. When there is this much variation and dispersion, the ability to draw conclusions about the impact of ABEX’s diversification and the company’s future total cash flow is very limited. Another point is that the mean assigns equal weights to each year’s cash flow which may not accurately reflect the current state of the business. For example, if total cash flows are increasing at an increasing rate, using the mean growth would underestimate the total future cash flows for the future. If total cash flows are decreasing at a decreasing rate, using the mean growth would overestimate the growth of total future cash flows. As a result, blindly using the mean to forecast future cash flows often ignores many important situational factors that will affect total cash flow in the near future. Finally, regression analysis usually predicts a linear trend. Linear trends are extremely rare and the fact that the diversification relationship on total cash flow is not perfectly correlated or not perfectly negatively correlated, a linear estimation of future total cash flows would be limited in accuracy. The dispersion present in the data would make linear regression estimation even more difficult. Thus, high volatility of pipeline cash flows, equivalent weights assigned to each year despite situational factors, and the bounds of linear regression analysis will limit using these data to draw conclusions about the impact of ABEX’s diversification into petrochemicals on the company’s future total cash flows. 4. A) Explain the differences between ABEX’s overall profitability in 1985 and in 1989. (Your analysis should include calculation and discuss of the impact of the components that determine ROE.) b) Explain why ABEX’s EPS almost doubled between 1985 and 1989 despite the decline in its ROE. A. Year ROE Financial Leverage Asset turnover 1985 9.4% 3.25 1989 9.2% 3.4 .46 .44 calculations NI/total equity Taken from table 3 Taken from table 3 EBIT Margin Interest Burden Tax Burden Net Profit Margin .227 .493 .245 .447 EBIT/Sales EBT/EBIT .561 6.4% .56 6.1% NI/EBT NI/Sales From 1985 to 1989, ROE for ABEX has actually dropped. By analyzing the components of ROE, we see that financial leverage has increased, asset turnover has decreased, profit margin has increased, interest burden has decreased, and tax burden has decreased. This indicates that ABEX has increased its use of debt to finance assets through increasing its financial leverage which increases the amount of risk the company has. If the company is in distress and can’t make its interest payments, this increase in leverage could force the company to go bankrupt. ABEX’s asset turnover has slowed meaning the company’s inventory is taking longer to convert into sales. ABEX’s EBIT margin has increased which is positive because this means that ABEX is bringing in a higher percentage of EBIT from its sales. Finally, both ABEX’s interest burden and tax burden have decreased which is a negative sign because we want tax burden, interest burden, profit margin, and asset turnover to be as high as possible in our ROE. ABEX’s overall profitability has declined from 6.4% to 6.1% which can be explained by its decrease in ROE from 9.4% to 9.2%. When we break down ROE into its components, we can see that the decrease in asset turnover, tax burden, and interest burden are hurting the firm’s overall net profit margin. As a result, if ABEX wants to improve its overall profitability, it should focus on improving its asset turnover, tax burden, and interest burden. In addition, while ABEX is already improving in its EBIT margin, further improvement of this margin would increase its ROE and improve its net profit margin. B. The reason for ABEX’s EPS almost doubling between 1985 and 1989 despite the decline in its ROE is the result of ABEX reducing the preferred dividend payment to its preferred stock shareholders. In 1985, ABEX paid out $77 million which was 58% of its net income and in 1989, ABEX paid out $17 million which was 7.6% of its net income. As a result, ABEX had much more of its net income leftover for earnings per share in 1989 despite a decrease in ROE. 6. With the widespread rise in takeovers, Dean decides to analyze the value of each of ABEX’s divisions separately. In this exercise, the following assumptions are made:    A 13% discount rate for the pipeline division, and a 15% discount rate for the petrochemical division; The dividend is paid in approximate proportion to the ratio of operating income (i.e., 40% of the dividend from the pipeline division and 60% from the petrochemical division); and Dividend growth will be 5% per annum in the pipeline division, and 9% per annum in the petrochemical division. A. Based on the above assumptions, calculate the value per share of each division using the dividend discount model. B) Briefly discuss the limitations of using the dividend discount model to estimate the value of ABEX. A. pipeline: 0.2*(1.05)/(0.13-0.05) = $2.625 petrochemical: 0.3*1.09/(0.15-0.09) = $5.45 Value of ABEX stock = $2.625 + $5.45 = $8.075 B. The limitations of using the dividend discount model to estimate the value of ABEX are:  It assumes continuous growth forever  Dividends may not reflect profitability of the firm  Not as closely related to book value as a residual income model As mentioned in class the dividend discount model assumes continuous growth forever which is unrealistic. With the growth rate of the US GDP under 5% per year, ABEX , with a growth rate between 5-9%, would eventually surpass the GDP of the US by itself. In addition, growth rate is rarely as constant as implied by the dividend discount model. With the large standard deviations of cash flows we saw from the petrochemical portion of the business, it would be highly unlikely that growth rate would be constant. One problem with the dividend discount model is that dividends don’t always reflect the profitability of the firm. If we look at the relationship between ABEX’s common dividends per share and its net income, they do not seem to be correlated. ABEX’s common dividends per share were $0.40 from 1985 to 1988 and $0.50 in 1989 but its net incomes from 1985 to 1989 were $56, $32, $101, $385, and $208 respectively. Despite changes in net income, the amount of dividends paid by ABEX per share did not change. As a result, we can conclude that dividends don’t reflect the profitability of the firm meaning that dividend discount model would not be a good indicator of the value of ABEX’s stock. Lastly, the dividend discount model does not have a strong relationship with book value compared to other models such as the residual income model. Because James Dean wishes to move away from the dividend discount model and more towards the book value method of valuation, the lack of strong a relationship between the dividend discount model and book value is a limitation of the model. In conclusion, the three main limitations of the dividend discount model are it assumes continuous and constant growth forever, dividends may not reflect profitability of the firm, and the model is not as closely related to book value. 7. Dean believes that, while a precise value for ABEX’s common stock is difficult to assess, its value relative to that of other similar firms can provide some useful insights. Using the information below and your answer to Part 6A, compare the value of ABEX common shares to those of DuPont and Dow, two other major petrochemical producers, and discuss the differences. Current market ABEX $9 DuPont $32 Dow $90 Average irrelevant value Book value per share 1990 EPS (estimated) 1990 dividends Dividend discount model value (DDMV) P/BV Ratio P/E Ratio Yield P/E ratio*EPS DDMV/market price $9 $22 $46 $25.67 $0.56 $2.80 $8.00 $3.79 $0.50 $8.075 $1.40 $35 $4.00 $100 Irrelevant Irrelevant 1 16.1 5.6% $9.016 $0.897 1.45 11.4 4.4% $31.92 1.1 1.96 12.5 4.4% $100 1.1 1.47 13.33 4.8% Irrelevant 1.0323 Because we are comparing three different firms, we need to use data that allows us to compare ABEX, DuPont, and Dow as fairly as possible. Current market price, book value per share, 1990 EPS, 1990 dividends, and the dividend discount model value are not useful by themselves but are useful once they are combined with other values. First, let’s compare the current market price for each company to its respective dividend discount model value. According to this, ABEX is currently overvalued at $9 because the dividend discount model values ABEX at $8.075. DuPont is currently undervalued as its DDMV is $35 while its current market price is $32 and Dow is also undervalued with a market price of $90 and a DDMV of $100. Strictly using the dividend discount model valuations, we can say that ABEX is still overvalued and the sell recommendation James Dean currently has on ABEX is accurate while DuPont and Dow are undervalued which justifies a buy rating for these two stocks. This is further supported when we look at the DDMV to market price ratios. ABEX has a DDMV/market price ratio of 0.89711 while DuPont and Dow have a ratio of 1.1. The higher this ratio is relative to other firms in the industry, the better. With the sample industry average (these 3 companies) of 1.0323, ABEX is the only company out of the three that is below our set benchmark which would indicate it is overvalued. Next, let’s analyze the price to earnings ratios known as the P/E ratio. A lower P/E ratio relative to other companies and/or the industry average is preferred. For these three companies, the average P/E ratio is 13.33. With ABEX’s P/E ratio of 16.1, its stock price is relatively overvalued when compared to DuPont’s P/E of 11.4, Dow’s P/E of 12.5, and the average P/E of these three companies of 13.33. A P/E ratio of 16.1 means that ABEX’s stock is currently trading at 16.1 times its earnings. Thus, using the P/E ratio, ABEX is relatively overvalued which also justifies the sell recommendation. Now let’s compare the market price to book value ratio of these three companies which is also known as P/BV. ABEX has a P/BV ratio of 1, DuPont has a ratio of 1.45, Dow has a ratio of 1.96 and the three company average is 1.47. Because lower P/BV ratios are better, ABEX would be considered undervalued relative to its industry when using the P/BV ratio to compare firms. In addition, in class, we learned that historically, the P/BV ratio has had a strong correlation to returns. If we look at only ABEX’s P/BV ratio without comparing it to anyone else, a ratio of 1 means that ABEX’s current market price is fairly valued. As a result, using the P/BV ratio to compare ABEX’s current market price to book value per share would indicate that its stock is fairly valued at $9 or it is undervalued when you compare the P/BV ratio to P/BV ratios of DuPont, Dow, and the sample average. Lastly, we will take a look at yield which is a much more controversial topic. ABEX has the highest yield of the three companies. This can be seen as positive because it means that the company is paying out more dividends for a higher rate of return for its shareholders. On the other hand, this means that less money is reinvested back into the business, decreasing the retention rate. As a result, some people may argue that this creates less opportunity for growth and capital appreciation. Thus, the higher yield of ABEX can be looked upon as positive or negative depending on point of view. 8. As a member of Dean’s research team, you must now come to a conclusion regarding ABEX’s stock. Based on your analysis and on all of the information provided, recommend and justify either a “buy” or a “sell” decision on the shares. In the introduction, we are given the statement: “Dean has traditionally valued companies on the basis of discounted cash flows, but he is now placing more emphasis on the quality of cash flow, earnings momentum, yield, book value and the components of income.” and that Dean’s original sell recommendation needed to be reevaluated as the stock’s price dropped from $15 to $9. Because the external factors mentioned in the introduction state that there is a threat of overcapacity in this industry which will cause operating rates to fall significantly, the earnings momentum of the company seems weak from its recent decline in net income and EPS, high relative P/E ratio relative to its competitors, and implied overvaluation of the stock’s current market price based on the DDMV, I would support the sell recommendation on ABEX that is already in place. Compared to DuPont and Dow, ABEX isn’t performing exceptionally well. The current overpriced value of ABEX that is in the market provided by the P/E ratio and the DDMV implies that ABEX’s stock still has more room to fall. The overall pessimistic outlook on the industry ABEX is in and the drop in Net Income and EPS in the past 2 years does not help either. In conclusion, I would support the sell recommendation that is currently on ABEX. For argument’s sake, some people may argue that ABEX has a good P/BV ratio, strong cash flows, and higher yields than its competitors. However, at best, its P/BV ratio and book value per share indicate that ABEX is fairly valued. In addition, despite the recent increase in total cash flows, the standard deviation of the cash flows is above 300 (from problem 3) which means that cash flows are extremely volatile. This high fluctuation in cash flow produces significant risk. Finally, while some may say higher yield when compared to other companies is good, it reduces the amount of capital reinvested back into the business. This will limit growth potential and the stock’s ability to appreciate in value. As a result, at best, I may be able to support a neutral rating on this stock but since the question asks for a buy or sell rating, I will support a sell recommendation on this stock for the reasons listed above.
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Explanation & Answer

HiPlease check the attached file for details, let me know if you have any questions, thank you again, Best, James,

1. Because there is inflation of 4%, the central bank intervenes and decreases the money stock
by 7%. Interest rates rise by 1%, or 100 basis points. Eventually, the intervention lowers the
GDP and the interest rates as well as inflation. The GDP, in fact, decreases by 1.5%, the
inflation rate becomes 1%, and the interest rates drop by 1.7%, or they fall from the initial level
by70 basis points (.7 %.) Divide the analysis into two areas. First, address the initial effect on
the bond and the stock market. Second, discuss both, after the effects have worked themselves out
as I have indicated above.
Initially, inflation increases by 4%, the central bank reacts by decreasing the money supply by 7%
decrease, which increases interest rates by 1%.
Result: Because of increase in inflation, the interest rates will increase and so does the cost of
equity. The increase in cost of equity causes the price of bonds and the stocks to decrease. The
reason can be illustrated by the formula of bond and stock evaluation.
The value of stock:
P = D1 / (i – g)
Where:
D1 = dividends in period 1
i= the cost of equity
g = the growth rate of dividend
From this equation, we can see when i increases, the price of the stock decrease with other factor
remaining the same.
To determine the value of bonds, we use the equation:
PV = FV / (1 + i)T
Where:
PV = present value
FV = face value
i = interest rates
T = time
It is easy to see that as interest rates increase, the present value of the bonds (which equal to the
price of the bond) decreases.
This also applies to coupon bonds, we have
PV = PMT (1-1/(1+i)T)/i + FV / (1 + i)T
where PMT is the coupon payment amount in one period. PV also decrease as I increases. In
conclusion, bond prices will decrease when there is an increase in inflation and interest rates.
After effect: GDP decrease by 1.5%, inflation decrease from 4% to 1%, interest rates decrease by
1.7%.
Results: the net effect of the intervention that causes GDP to decrease by 1.5%, inflation to
decrease by 3%, and interest rates to decrease by 1.7%, and the price of stocks and bonds will
increase as we illustrated above that decrease in interest rate will increase the price of bonds and
stocks.

2. Expound on an expansion in GDP and the effects on the stock market and bond market in two
different cases. First, the economic growth does not induce inflation. Second, the economic
expansion causes substantial increase in inflation. Specifically, the GDP rises by 2.5% and the
inflation rises by 5.5%.
In the first case, GDP raises autonomously. This will cause demand of money to increase, and
interest rates to increase, hence cost of equity to increase. The effect on the stocks and bonds can
be explained by again using the formula below:
P = D1 / (i – g)
Since increase in GDP and the growth of the cash flows will increase the dividends paid by
companies, the price will increase. Although the cost of equity also increases, it is compensated
by the larger increase in dividends and growth which causes the net effect on price to be an
increase.
For the bond,
PV = FV / (1 + r)T
We see that the increase in cost of equity will increase the denominator which will decrease the
present value of the bond and reduces the bond prices.
Thus, an environment where GDP raises autonomously will increase the price of stocks but
reduce the price of bonds.
In the second case, GDP rises by 2.5% and inflation rises by 5.5%. Because the change in
inflation is larger than the change in GDP, the effects of inflation will be stronger and the
increasing in dividend paid by the company can’t offset the increase in inflation. Thus, the
increase in inflation will cause interest rates to rise by a greater amount than the increase in GDP
and dividend and we have the net effect of prices of both bonds and stocks will decrease when
inflation rises by 5.5% and GDP rises by 2.5%. However, this would be different if the GDP
growth was greater than the inflation, because the increase in cash flow could offset the
reduction in stock price by increasing in inflation.
3. How do we forecast GDP? Explain the different components of it and the determinants of
those components.
GDP can be calculated by the equation:
GDP = C + I + G + (X-M)
in above equation, C is consumption, I is investment, G is government spending, and (X-M) is
net exports. It measures the nation’s economic activity in monetary value of goods and services
produced within a nation during a specific period of time. There are several ways to forecast
GDP. The first one is to use econometrics with a comprehensive sequence of formulas. While
this may be the most accurate way, it is very costly. The second way is to forecast each
components of GDP and add them together. By examining the determinants in consumption,
investment, government spending, and net exports, we can predict these components and thus

forecast future GDP. However, figuring out the growth of each of these components is not easy
either, because various assumptions that affect the forecast would have to be made. The last way
is to use stock market to forecast GDP, because the economy is positively correlated with the
stock market but the economy lags behind the stock market by a period of time.
Consumption is the sum of the final purchases of goods within a nation. For example, if a
machine is made in California, packaged in New Jersey, and sold in Maryland, only the price it
sold in Maryland should be added to GDP as consumption. It is the largest part of GDP and it is
very important to a healthy economy. The determinants of consumption are GDP (Income) and
expectations of GDP, stock of consumption durables, and tax policy. Because GDP affects
income, it also affects consumption. This is easy to understand since people tend to increase
spend when they have more income and reduce spend when they have less income. Thus, if GDP
grows, income will also grow, which leads to increase consumption. Expectations of GDP also
affect consumption because people spend more if they believe GDP will grow and they will have
higher income in the future. In contrast, if people believe that the economy will crash and their
incomes will decrease, they will save more money for the future. The amount of durables an
individual has also affects consumption. When one has more durables, he or she will consume
less in the future, comparing someone who has less durables and will need to buy items in the
near future. The last determinant of consumption is tax policy, which has an inverse relationship
with consumption. Since as taxes go up, it effectively reduces people’s income, thus they will
consume less and savings rise. On the contrary, as taxes go down, people have more income to
spend and consume more.
Investment includes buying fixed assets such buildings, equipment, commercial housing, ets.,
that allow businesses to grow and produce cash in the future. Similar to consumption, the final
sale on these items is what would be included in the investment component of GDP. For example,
a house that is sold for the first time would be counted as investments but the reselling of a house
would not. The determinants of real investment are GDP, expectations, stock of real investment,
interest rates, and tax policy. GDP and expectations of GDP affect investment in similar ways as
they affect consumption. When GDP or expectations of GDP rise, so does investing and when
GDP or expectations of GDP fall, investment decreases. Also similar to consumption, stock of
real investment reduces the amount of investment. The residential housing portion of
investments is affected by interest rates. Housing and interest rates are negatively related. When
interest rate goes up, the housing investment goes down. Also, similar to consumption, tax policy
also influences investment in the same way. When tax goes up, investment will decrease and
when tax policy does down, investment decreases.
Government spending is the sum of total government expenditures on final products and services,
including military defense, public services, construction of highways, and the wages of those
employed by the government. The amount of money that the government has is determined by
fiscal policy which creates a budget surplus or deficit depending on the difference between how
much the government spends and the amount collected through tax policies. The only
determinant of government spending is politics but it has many factors that ultimately decide
how much the government can spend and add to GDP. When the economy is not doing well, the
government tries to improve the economy by spending more, which is known as expansionary
policy.

Net exports is the difference between exports minus imports. Net export is determined by GDP
and the competitiveness of the country. GDP determines the income of a country. The lower the
GDP, the higher the net export because the country will export less and import more. The
competitiveness of a country relates to the relative prices of its good and services and the
exchange rate. If a country’s goods and services are cheap compared to the rest of the world, it
will have higher exports and lower imports. In addition, if a country has a weaker currency, it
will also experience an increased amount of exports and a decreased amount of imports.
Therefore, in general, countries with high GDP, strong currency, and high price levels will likely
have a negative net exports balance while countries with low GDP, weak currency, and low price
levels will likely have a positive net exports balance.
4. What tools have we got to foretell the values of the portions of the GDP?
The tools we have to foretell the values of the portions of GDP are quarterly GDP reports,
employment reports, inflation reports, consumer spending reports, income reports, and other
economic reports that are released periodically throughout the year. They allow us to evaluate
the different portions of GDP during different periods of time. Looking at past economic data
combined with analysis and econometrics will allow us to foretell the values of the portions of
GDP.
Another way to foretell values of the portions of GDP is to predict GDP first and then predict
how that affects the portions of GDP. As mentioned in the previous question, GDP is the sum of
consumption, investments, and net exports. Thus, we can predict the values of these portions if
we have an estimate of GDP. One way we can estimate GDP is through the relationship that a
country has with its stock market. In the US, the stock market has been an accurate leading
indicator for the US economy. Whenever the stock market crashed, the US economy would enter
a recession soon after. Thus, if the stock market crashes and we believe GDP will fall soon, we
can conclude that consumption and investing ...


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