Equity Valuation, Arbitrage and Fixed Income Securities Valuation Problem Set

Equity Valuation
1. Suppose that the consensus forecast of security analysts of your favorite company is that
earnings next year will be E₁=$5.00 per share. Suppose that the company tends to plow back
50% of its earnings and pay the rest as dividends. If the Chief Financial Officer (CFO) estimates
that the company’s growth rate will be 8% from now onwards, answer the following questions.
a) If your estimate of the company’s required rate of return on its stock is 10%, what is the
equilibrium price of the stock [hint: use the GGM]?
b) Suppose you observe that the stock is selling for $50.00 per share, and that this is the best
estimate of its equilibrium price. What would you conclude about either (i) your estimate of the
stock’s required rate of return; or (ii) the CFO’s estimate of the company’s future growth rate?
c) Suppose your own 10% estimate of the stock’s required rate of return is shared by the rest of
the market. What does the market price of $50.00 per share imply about the market’s estimate
of the company’s growth rate?

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