Econ 156 Fall 1999 Midterm

Answer all 10 questions, leaving tedious calculations undone. The test ends promptly at 2:30. ALWAYS explain your reasoning.

All of these questions are based on James K. Glassman and Kevin A. Hassett, "Dow 36,000," The Atlantic Monthly, September 1999, pp. 37-58.

1. Consider a normal bond that pays $1 a year forever and a growth bond that also lasts forever, but whose payments increase by 2% each year: $X the first year, $X(1.02) the second year, $X(1.02)^2 the third year, and so on. If the bonds sell for the same price, for what value of X is the interest rate on these two bonds equal to 5%? (Give a definite numerical answer.)

2. Cisco Systems' earnings grew at a 59% annual over the past 5 years. In June 1999, its earnings per share were $0.74 and its stock was selling for $64 a share; it pays no dividends and has essentially no debt. Let's analyze the firm at that time. Suppose its earnings per share grow at a 59% annual rate for the next five years and then grow at a 4.5% rate forever and that, beginning five years from now, it pays out 70% of its earnings as dividends. If shareholders require a 5.5% return, what current price is justified by fundamental analysis?

3. Is the duration of Cisco Systems stock larger or smaller than 5 years?

4. The Cisco analysis used a 5.5% annual return because that was the prevailing interest rate on Treasury securities. What peculiar assumption is made when the shareholders' required return is set equal to a Treasury rate? Is it an important assumption here?

5. At the time, short-term Treasury bill rates were 5.5% and long-term Treasury bond rates were 6.0%. Which do you believe is more relevant to shareholder required return? Does it matter much?

6. Would the justified price in question 2 be higher or lower if we have a 3% inflation that does not affect the real growth rate of earnings and dividends and does not affect the shareholders' real required return? Explain.

7. Other things being equal, what would be the fundamental value of Cisco Systems stock if the long-term growth rate of earnings were 10%?

8. What profit rate is consistent with Cisco's 59% annual growth rate of earnings?

9. Even though it does not need to borrow to finance its expansion, how might Cisco shareholders benefit if Cisco were to borrow money and use the proceeds to repurchase its stock?

10. Explain the logical error in this remark: "shareholders appear to be indifferent to whether their companies pay dividends or retain earnings. If the firm you own earns $5.00, it is your $5.00 whether the firm formally hands you the money or not."

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