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You are a financial analyst for a hedge fund and need to determine the value of the stock of NewEquity Inc. NewEquity Inc. is a

You are a financial analyst for a hedge fund and need to determine the value of the stock of NewEquity Inc. NewEquity Inc. is a new and growing corporation.

The following table describes the characteristics of NewEquity Inc:

As NewEquity Inc. is a new company; thus, they are not expected to pay any dividends until the end of Year 3. The following are predictions for NewEquity Incs earnings per share (EPS) in Year 3:

Stock

Covariance of stock with the market

Current stock price

NewEquity Inc.

0.035

$60

State

EPS

Probability

Great

$7

25%

Good

$6.5

25%

Average

$5

30%

Bad

$0

20%

The payout ratio for NewEquity Inc. is 60% p.a. and the return on equity (ROE) IS 10% p.a. This is expected to be constant forever. The expected stock market risk premium is 6^ p.a., the risk-free rate is 3% p.a., and the market standard deviation is 20% p.a. Assume that all rates given are compounded annually.

(a). Using the CAPM, what is the required rate of return of NewEquity Incs stock? (b). Using the expected value of dividends and assuming that the CAPM is correct, what should the price of NewEquity Incs stock be today? (c). Instead of the current payout policy, suppose NewEquity Inc. decides to pay out all their earnings as dividends forever. What would the intrinsic value of NewEquity Incs stock be now? (d). Instead of the current payout policy, suppose NewEquity Inc. decides to change its payout ratio to 30% forever. What would the intrinsic value of NewEquity Incs stock be now? (e). Have the intrinsic values for parts (c) and (d) changed or not? Explain why or why not. If you were a shareholder of NewEquity Inc., which payout policy would you prefer? Explain your choice. (f). Assume that the calculations part (d) is the forecasted price for NewEquity Inc. in one years time. What would be your rate of return if you purchased the stock today at the current price and sold it in one years time? (g). Suppose you discover leaked information that NewEquity Inc. will be changing their payout ratio to 20% forever. If the market is: (a) weak-form efficient, (b) semi-strong efficient, or (c) strong efficient, could you gain abnormal returns from this information? Why or why not? Explain your answer under each form of market efficiency

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