Assignment #3 – California Clinics (Due February 16, 2011) California Clinics, an investor-owned chain of ambulatory care clinics, just paid a dividend of $2 per share. The firm’s dividend is expected to grow at a constant rate of 5% per year, and investors require a 15 % rate of return on the stock. 1. Given: D₀= the most resent dividend which is = $2.00 per share. E (g) = The constant growth rate = 5% = 0.05 per year. R(Re) = Investors rate of return on the stock = 15% = 0.15 Formula used E (P₀) = D₀ x (1 + E (g)) / (R(Re)-E(g)) E (P₀) = $2.00 x ( 1+ 0.05) / (0.15- 0.05) E (P₀) = $2.00 x ( 1.05) / ( .1) E (P₀) = $2.10 / .1 E (P₀) = $ 21.00 There for the stock value is $21.00 What is the stock’s value?
Suppose the riskiness of the stock decreases, which causes the required rate of return to fall to 13%. Under these conditions, what is the stock’s value? Given: D₀= the most resent dividend which is = $2.00 per share. E (g) = The constant growth rate = 5% = 0.05 per year. R(Re) = Investors rate of return on the stock = 13% = 0.13 Formula used E (P₀) = D₀ x (1 + E (g)) / (R(Re)-E(g)) E (P₀) = $2.00 x ( 1+ 0.05) / (0.13- 0.05) E (P₀) = $2.00 x ( 1.05) / ( .08) E (P₀) = $2.10 / .08
E (P₀) = $ 26.25 There for the stock value will increase due to the the required rate of return to falling which: $26.25
Return to the original 15% required rate of return and assume a dividend growth rate estimate increase to 7% per year, what is the stock value? Given: D₀= the most resent dividend which is = $2.00 per share. E (g) = The constant growth rate = 7% = 0.07 per year. R(Re) = Investors rate of return on the stock = 15% = 0.15 Formula used E (P₀) = D₀ x (1 + E (g)) / (R(Re)-E(g)) E (P₀) = $2.00 x ( 1+ 0.07) / (0.15- 0.07) E (P₀) = $2.00 x ( 1.07) / ( .08) E (P₀) = $2.14 / .08 E (P₀) = $ 26.75 There for the stock value is $26.75 Explain how each of the four (4) fundamental factors that affect the supply and demand for investment capital, and hence, interest rates, (namely productive opportunities, time preferences for consumption, risk, and inflation) affects the cost of money. The four (4) fundamental factors that affect the supply and demand for investment capital, and hence, interest rates, (namely productive opportunities, time preferences for consumption, risk, and inflation) affects the cost of money. 1. Investment opportunities: This concept deals with higher the profit a person gain from the business the more interest rate they can afford to pay off their debt. For example, In today's market only true wealth you can have is money and bonds, therefore the money is use to purchases bonds and bonds are redeemed for money. They are both different in some way, money usually pays very small interest rate some times not at all and it is also use to purchases goods and serveries on the other hand bands do pay interest rate and you cannot purchases any goods and serveries unless you convert the bond in to cash. Therefore people use some of their money to buy bonds, if the bonds' interest rate increases the demand for bonds will increase as well. Due to supply demand relationship as the demand of bonds will increase the supply will decrease. 2. Time Preferences for Consumption: This consept deals with future and currnt
decision of potential leaders about their funds. For example if the person is saving their money for retirement therefore they are willing to loan funds at low interest rate because there preferences is for the future consumption therefore the time preference consumption will be low . On the other hand a person with family to support will be willing to loan funds out of current income. Therefor he or she will be paying high interest rate due to their preference for consumption in current situation therefore the time preference consumption will be high. If we were to relate this concept with supply demand, if the interest rate was high the demand for loan will decrease and supply will increase and vise-verse. 3. Risk: In any business the factor of risk holds lots of importance because in business people take lot of risk to gain profit. The higher the risk the higher interest rate because when person takes-up a loan for a new business the investors have very low expectation for a business to be successful therefore they get their money from the higher interest rate that they provide to the lenders as the business become successful the interest rate become little lower. Investor would invest their money in low-risk business rather then high-risk business. 4. Inflation: This concept deals with the future of money; the higher the inflation rate the higher the interest rate. When there is higher interest rate the demand of loan will decrease and supply will increase. In other words inflation is the power of your dollar to purchase good with it. As the price increase the power of dollar decreases for example the gas prices few years ago with 20 dollars you can fillup a tank of gas now with same price only half can be filled. Why is risk aversion so important to financial decision making? Risk aversion so important to financial decision making because both the individual and the business investor don't live risk. For example a person is given two choices one is $10,000 for sure and if they played second around they can get twice as much if they win and if they don't win they can lose all their money and get nothing now a person who takes $10,000 is called risk averse. Although some people will take lots of risk with there investments but for this kind of behavior requited lots of money to back it up therefore they have lots of saving to run their life so it doesn't effect them if they lose money . Majority of business owners are very low risk takers because they don't want to put their wealth on risk therefore most of them are risk aversion. Another risk aversion so important to financial decision making is when it comes to business investment because there are two alternative to high-risk and low-risk investment. Explain the three (3) techniques for solving time value problem. There are many ways for solving time value problem we can solve problem using mathematical multipliers obtained from the table which was used to solve the problem. “At one time, table were the most efficient way to solve time value problems, but calculator and spreadsheets have made the table obsolete ( Berkowitz, 2006, Page 300).
References Berkowitz, Eric N. 2010, PhD, Essentail of Healthcare Marketing, 2nd ed, The University of Massachusetts.