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Chapter Seven

Principles of Market Valuation

This chapter contains 30 multiple choice questions, 10 short problems and 5 longer problems. Multiple Choice

1.In regard to an asset, the ________ is defined as the process well-informed investors must

pay for it in a free and competitive market.

(a)analyst value

(b)technical value

(c)competitive value

(d)fundamental value

Answer: (d)

2.In corporate finance decision making, an extremely important rule is to choose the investment

that ________ current shareholders’ weal th.

(a)minimizes

(b)maximizes

(c)provides zero change in

(d)jeopardizes

Answer: (b)

3.In asset valuation, the method used to accomplish the estimation depends on the ________.

(a)number of participants

(b)quality of calculating instruments

(c)richness of the information set available

(d)geographic location

Answer: (c)

4.The ________ states that in a competitive market, if two assets are equivalent, they will tend

to have the same market price.

(a)Law of Real Interest Rates

(b)Law of One Price

(c)Law of Price Equivalency

(d)Law of Futures

Answer: (b)

5.The Law of One Price is enforced by a process called ________, the purchase and immediate

sale of equivalent assets in order to earn a sure profit from a difference in their prices.

(a)swapping

(b)maximization

(c)arbitrage

(d)speculation

Answer: (c)

6.________ refers to the totality of costs such as shipping, handling, insuring, and broker fees.

(a)Shipping costs

(b)Transaction costs

(c)Installation costs

(d)Insurance costs

Answer: (b)

7.The Law of One price is a statement about the price of one asset ________ the price of

another.

(a)absolute to

(b)relative to

(c)multiplied by

(d)independent of

Answer: (b)

8.If an entity borrows at a lower rate and lends at a higher rate, this is an example of ________.

(a)opportunity arbitrage

(b)interest-rate arbitrage

(c)exchange arbitrage

(d)nominal arbitrage

Answer: (b)

9.If arbitrage ensures that any three currencies are freely convertible in competitive markets,

then:

(a)it is enough to know only one exchange rate to determine the third

(b)we can estimate two exchange rates based on one exchange rate only

(c)it is enough to know the exchange rates between any two in order to determine the

third

(d)it is necessary to know all three rates

Answer: (c)

10.Suppose you have $15,000 in a bank account earning an interest rate of 4% per year. At the

same time you have an unpaid balance on your credit card of $6,000 on which you are paying an interest rate of 17% per year. What arbitrage opportunity do you face?

(a)$240 per year

(b)$600 per year

(c)$780 per year

(d)$1,020 per year

Answer: (c)

11.If the dollar price of Japanese Yen is $0.009594 per Japanese Yen and the dollar price of

Chinese Yuan is $0.1433 per Chinese Yuan, what is the Japanese Yen price of a Chinese Yuan? (i.e., JPY/CNY)

(a)0.001375 JPY/CNY

(b)0.066950 JPY/CNY

(d)14.936419 JPY/CNY

Answer: (d)

12.If the dollar price of guilders is $0.5634 per Guilder and the dollar price of Euros is $1.5576

per Euro, what is the Euro price of the Guilder? (i.e., EUR/ANG)

(a)0.361700 EUR/ANG

(b)0.877552 EUR/ANG

(d)5.634 EUR/ANG

Answer: (d)

13.Suppose the price of gold is 51.09 British pounds per ounce. If the dollar price of gold is

$100 per ounce, what would you expect the dollar price of a British pound to be?

(a)$1.95733 per GBP

(b)$1.5109 per GBP

(c)$0.5109 per GBP

(d)$0.4891 per GBP

Answer: (a)

Questions 14-18 refer to the following exchange rate table. To answer 14-18 you will have to fill in the missing exchange rates.

14.What is the Euro/Peso exchange rate? (i.e., EUR/MXN)

(a)0.617426EUR/MXN

(b)0.641807 EUR/MXN

(d)16.196262 EUR/MXN

Answer: (a)

15.What is the Cdn Dlr/Euro exchange rate? (i.e., CAD/EUR)

(a)0.641807 CAD/EUR

(b)1.558099 CAD/EUR

(d)16.196262 CAD/EUR

Answer: (b)

16.What is the Euro/Cdn Dlr exchange rate? (i.e., EUR/CAD)

(a)0.3583 EUR/CAD

(b)0.641807 EUR/CAD

(d)10.394 EUR/CAD

Answer: (b)

17.What is the Peso/Cdn Dlr exchange rate? (i.e., MXN/CAD)

(a)0.096201 MXN/CAD

(b)0.641807 MXN/CAD

(d)16.196262 MXN/CAD

Answer: (c)

18.What is the Peso/Euro exchange rate? (i.e., MXN/EUR)

(a)0.617426 MXN/EUR

(b)6.675516 MXN/EUR

(d)16.196262 MXN/EUR

Answer: (d)

19.You are travelling in FarOut where you can buy 130 kranes (a krane being the unit of

currency of FarOut) with a U.S. dollar at official FarOut banks. Your tour guide has a relative who dabbles in the black market and this particular relative will sell you kranes for just

$0.00833 each on the black market. How much will you lose or gain by exchanging $200 on the black market instead of going to the bank?

(a)you would gain approximately 1,660 kranes

(b)you would lose approximately 1,660 kranes

(c)you would gain approximately 1,990 kranes

(d)you would lose approximately 1,990 kranes

Answer: (d)

20.In estimatin g the value of a share of a firm’s stock, a simple model is to :

(a)divide EPS by a P/E multiple

(b)multiply EPS by a P/E multiple

(c)multiply EPS by EAT

(d)divide EPS by market value

Answer: (b)

21.A firm’s earnings per share are $6 and the industry average P/E mult iple is 9. What would be

an estimate of the value of a share of the firm’s stock?

(a)$54.00

(b)$45.00

(c)$1.50

(d)$0.67

Answer: (a)

22.The value of the asset as it appears in the financial statement is called the asset’s ________.

(a)market value

(b)fixed value

(c)book value

(d)expected value

Answer: (c)

23.Consider the following stock market reaction to the information contained in a company’s

announcement. A corporation has just announced that it must pursue the issuance of company equity. We could expect to see ________ in the price of company stock.

(a)a rise

(b)a drop

(c)a rapid rise

(d)zero change

Answer: (b)

24.Consider what the stock market reaction to the following announcement would be. A

corporation has just announced that it is engaging in a stock split of the company’s shares.

We could expect to see a ________ in the overall market capitalization rate and a ________ in the price of company stock.

(a)rise; drop

(b)drop; rise

(c)rise; drop

(d)rise; drop

Answer: (a)

25.The ________ is the proposition that an asset’s current price fully refle cts all publicly

available information about future economic fundamentals affecting the asset’s value.

(a)public markets hypothesis

(b)efficient markets exchange rates

(c)fundamental value proposition

(d)efficient markets hypothesis

Answer: (d)

26.The market price of an asset reflects the ________ of all analysts’ opinions with heavier

weights on analysts who control large amounts of money and on those analysts who have better than average information.

(a)best estimate

(b)weighted average

(c)highest estimate

(d)lowest estimate

Answer: (b)

27.Assume that the worldwide risk-free real rate of interest is 4% per year. Inflation in Denmark

is 9% per year and in the United States it is 7% per year. Assuming there is no uncertainty about inflation, what are the implied nominal interest rates denominated in Danish krone and in U.S. dollars, respectively?

(a)16.63% (DKK); 13.50% (USD)

(b)13.50% (DKK); 16.63% (USD)

(d)11.28% (DKK); 13.36% (USD)

Answer: (c)

28.The ________ theory states that the expected real interest rate on risk-free loans is the same

all over the world.

(a)nominal interest-rate parity

(b)real interest-rate parity

(c)efficient inflation rate parity

(d)efficient market rate

Answer: (b)

29.________ states that exchange rates adjust so as to maintain the same “real” pr ice of a

“representative” basket of goods and services around the world.

(a)Purchasing power parity

(b)Efficient markets hypothesis

(c)Market valuation model

(d)Exchange rate equity

Answer: (a)

30.Assume that the worldwide risk-free real rate of interest is 5% per year. Inflation in Australia

is 9% per year and in Great Britain it is 12% per year. Assuming there is no uncertainty about inflation, what are the implied nominal interest rates denominated in Australian dollars and Great Britain pounds, respectively?

(a)22.08% (AUD), 11.45% (GBP)

(b)11.45% (AUD), 22.08% (GBP)

(d)14.45% (AUD), 17.60% (GBP)

Answer: (d)

Short Problems

1.Suppose you have $20,000 in a bank account earning an interest rate of 4% per year. At the

same time you have an unpaid balance on your credit card of $7,000 on which you are paying an interest rate of 18% per year. What is the arbitrage opportunity you face?

Answer: You could take $7,000 out of your bank account and pay down your credit card balance. You would give up 4% per year in interest earnings ($280) but you would save

18% per year in interest expenses ($1,260). So the arbitrage opportunity is worth $980

per year.

2.Fill in the missing exchange rates in the following table:

Answer:

3.You observe that the dollar price of the Mexican peso is $0.09618 and the dollar price of the

Canadian dollar is $0.9997. What must the exchange rate between the Mexican peso and the Canadian dollar be for there to be no arbitrage opportunity?

Answer: CAD/MXN = 0.09618

0.9997

= 0.096208 CAD/MXN

4.Suppose that the exchange rate is $0.2970 to the Israeli shekel. How could you make

arbitrage profits with $10,000 if the dollar price of gold is $200 per ounce and the shekel price is 750 ILS per ounce?

Answer: Take $10,000 and buy 50 ounces of gold at $200 per ounce. Sell 50 ounces of gold in Israel for 37,500 ILS (750 ILS per ounce). Take 37,500 ILS and exchange it into dollars worth $11,137.50. The arbitrage profit is $1,137.50.

5.You are travelling in FarOut where you can buy 150 kranes (a krane being the unit of

currency in FarOut) with a U.S. dollar at official FarOut banks. Your tour guide has a relative who dabbles in the black market and this particular relative will sell you kranes for just $0.00685 each on the black market. How much would you gain or lose by exchanging $300 on the black market instead of going to the bank?

Answer:

On the official market: $300 x 150 kranes = 45,000 kranes

On the black market: $300 x 1/0.00685 kranes = 43,796 kranes

Hence, you would lose 1,204 kranes.

6. A firm’s earnings per share are $5.50 and the industry average P/E multi ple is 8. What would

be an estimate of the value of a share of the firm’s stock? Is it possible for firms being classified in the same industry to have different price/earnings multiples?

Answer:

Estimated value share of stock = firm’s EPS x Industry ave rage P/E

= $5.50 x 8

= $44.00

Firms classified as being in the same industry may have different opportunities for growth in the future and may therefore differ in their P/E multiples.

7.The P/E multiple of BHM Corporation is currently 5, while the P/E ratio of the S&P 500 is

10. What reasons could account for this difference?

Answer:

?BHM’s reported earnings may be higher than they are expected to be in the future, or they may be inflated due to special accounting methods used by BHM.

?BHM may be riskier than the S&P 500 either because it is in a relatively risky industry or has a relatively higher debt ratio.

8.The price of Hubris Co. stock recently jumped when the CEO for the company announced an

increased dividend payment for the year. What might account for such a market reaction?

Answer: The market may believe the company’s future prospects look very bright (that is, higher earnings, less risk, sound growth, etc.) and that the company can sustain such an earnings growth.

9.Assume that the worldwide risk-free real rate of interest is 4% per year. Denmark has an

expected rate of inflation of 9% per year and in Spain has an expected rate of inflation of 14% per year. Assuming there is no uncertainty about inflation, what are the implied nominal interest rates denominated in Kroner and Euros?

Answer: Denmark: nominal interest rate = (1.04) x (1.09) – 1

= 13.36% per year

Spain: nominal interest rate = (1.04) x (1.14) –1

= 18.56% per year

10.Assume that the worldwide risk-free real rate of interest is 4% per year. The United Kingdom

has an expected rate of inflation of 8% per year and in Belgium it is 10% per year. Assuming there is no uncertainty about inflation, what are the implied nominal interest rates denominated in Pounds Sterling and Euros?

Answer: United Kingdom: nominal interest rate = (1.04) x (1.08) – 1

= 12.32% per year

Belgium: nominal interest rate = (1.04) x (1.10) – 1

= 14.40% per year

Longer Problems

1.Let’s assume that you have operated your own business for 18 years. For the most recent

fiscal year, sales were $15 million. Net Income for the most recent fiscal year was $1.5

million. The book value of your business was $11 million. Recently, a firm which is engaged in similar activities to your own was sold and the following information was made public: Multiple of Book Value 0.8x

Multiple of Net Income 11x

Multiple of Sales 0.7x

a)How would you determine an appropriate range of value for your company?

b)It has come to your attention that your company has future investment opportunities

that would be less profitable than the competing company above. What does this say

about the valuation of your company?

Answer: a) Multiple of Sales: 0.7x = $15 million x 0.7 = $10.5 million

Multiple of Net Income: 11x = $1.5 million x 11 = $16.5 million

Multiple of Book Value: 0.8x = $11 million x 0.8 = $8.8 million

b) The valuation of your company would be at the lower end of the range.

2.BHM stock is trading for $47 per share on the NYSE and $45 per share on the Sydney Stock

Exchange. Assume that the costs of buying and selling BHM stock are negligible.

a)How can you make an arbitrage profit?

b)Over time what would you expect to happen to stock prices in New York and Sydney?

c)Now assume that the cost of buying and selling shares of BHM are 2% per

transaction. How does this affect your answers?

Answer: a) You could buy BHM stock in Sydney and simultaneously sell it in

New York. Your arbitrage profit would be $2 per share.

b)The prices would become equal.

c)There could remain a 2% discrepancy between the prices which

would be $1.84 in this instance.

3.Suppose you have $50,000 in a bank account earning an interest rate of 3.5% per year. At the

same time you have an unpaid balance on your credit card of $13,000 on which you are

paying an interest rate of 21% per year. What is the arbitrage opportunity you face?

Answer: You could take $13,000 out of your bank account and pay down your credit

card balance. You would give up 3.5% per year in interest earnings ($455) but you would save 21% per year in interest expenses ($2,730). So the arbitrage opportunity is worth

$2,275 per year.

4.The quotes from Hubris Bank and Modesty Bank are given below:

Hubris Bank: 106 Yen/$

Modesty Bank: 104 Yen/$

Answer the following questions based on these figures.

a)If we assume no transaction costs, there is evidently an opportunity for arbitrage here.

If an arbitrageur started with $10,000, exactly how would (s)he make profits and

how much profit would (s)he make?

b)As many traders engage in arbitrage who do you expect to see in the above quotes at

these two banks?

c)If there is a 1% transaction cost for transactions is there still an opportunity for

arbitrage?

Answer:

Hubris Bank: 106 Yen/$ Modesty Bank: 104 Yen/$

a)At Hubris Bank, buy Yen with dollars (Yen are cheaper).

At Modesty Bank, buy dollars with Yen (dollars are cheaper).

Start with $10,000:

At Hubris Bank: $10,000 x 106 Yen/$ = 1,060,000 Yen

At Modesty Bank: 1,060,000 Yen x 1$/104 Yen = $10,192.31

You make a profit of $192.31.

b)The Yen will appreciate at Hubris Bank and it will depreciate at Modesty Bank.

Eventually the exchange rate will stabilize between 106 Yen/$ and 104 Yen/$.

c)Assume 1% transaction cost.

At Hubris Bank: $10,000 (0.99) x 106 Yen/$ = 1,049,400 Yen

At Modesty Bank: 1,049,400 Yen x (0.99) x $1/104 Yen = $10,090.38

There is still an opportunity for arbitrage profit, but it has decreased from

$192.31 to $90.38.

5.In the United States, the real rate of return is expected to be 5% and in Switzerland it is

expected to be 4%.

a)If the inflation rate in the United States is expected to be 6% and the Swiss

inflation rate is expected to be 8%, what will the nominal interest rates be in the

United States and Switzerland?

b)Are these markets in equilibrium? Where would you prefer to invest and why?

c)What if the Swiss inflation rate were 6%? Are the markets in equilibrium?

d)What are the respective nominal rates if the worldwide risk-free real rate of

return is 4% and inflation in the U.S. is 6% and in Switzerland it is 8%?

Answer:

a) United States: Nominal interest rate = (1.05)(1.06) – 1

= 11.30% per year

Switzerland: Nominal interest rate = (1.04)(1.08) – 1

= 12.32% per year

b)The markets are not in equilibrium. Investors will go where the real rate is highest.

That is, in the U.S.

c) United States: Nominal interest rate = (1.05)(1.06) – 1

= 11.30% per year

Switzerland: Nominal interest rate = (1.04)(1.06) – 1

= 10.24% per year

Markets are still not in equilibrium.

d) United States: Nominal interest rate = (1.04)(1.06) – 1

= 10.24% per year

Switzerland: Nominal interest rate = (1.04)(1.08) – 1

= 12.32% per year

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