Alex Forman is an equity analyst working for Parachute Investments (PARIN), an equity management firm offering investment

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Alex Forman is an equity analyst working for Parachute Investments (PARIN), an equity management firm offering investment advisory and management services to institutional as well as private wealth clients. Forman works with Cindy Pon to manage GLOMES fund, an equity fund that invests in domestic as well as global equities. Presently, Forman has asked Pon to use the internal rate of return (IRR) concept to determine a required return estimate for the stock of Vivo Products Inc. (VIVO), a firm operating in the utilities industry. For this purpose, Pon determined that the forecasted dividend for next year is $5.06/share, the current long-term dividend growth rate equals 3.95% and the expected dividend growth rate equals 3.28%. The stock’s current market price is $67.29. She then made the following comments to Forman:

Statement 1: “I have used the above information to determine a required return estimate of 10.80% for VIVO’s stock. However, my calculation model does not explicitly include an adjustment for risk and the estimate holds true only if the market is efficient.”

Statement 2: “My method of determining the required return is very similar to the exercise of inferring what the market implies about future growth rates of cash flows, given an independent estimate of required return.”

As their discussion about return estimates continued, Forman stated that an accurate equity risk premium estimate played an essential role in increasing the accuracy of the required return estimate. When Pon asked about whether to use the geometric or arithmetic mean in calculating the risk premium, Forman stated that the major finance models were single period models, so the arithmetic mean was a model-consistent choice. However, he added that compounding forward using the sample arithmetic mean, even when returns are serially uncorrelated, overestimated the expected terminal value of wealth. Pon disagreed, and stated that the geometric mean is the logical choice for estimating a required return in a multi-period context, even when using a single-period required return model. She also stated that risk premium estimates based on the geometric mean have tended to be closer to supply-side and demand –side estimates from economic theory than arithmetic mean estimates.

After their meeting, Forman proceeded with estimating the equity risk premium for U.S. equities using information about a broad-based equity market index. Exhibit 1 displays some data he accumulated for this purpose.

Exhibit 1 Data for U.S. Equity Markets

YTM of 20-year maturity T-bonds 5.6%
YTM of 20-year maturity TIPS 3.01%
Labor productivity growth 1.1%
Population growth rate 1.13%
Increase in labor force participation rate 2.01%
Expected dividend yield 3.5%
Reinvestment return 40 bps
Current long-term corporate bond yield 7.5%

*The U.S. risk-free rate is 4.5%

In addition, Forman expects the corporate earnings to grow at a rate faster than the growth rate of the overall economy. His estimate of this surplus growth is 1.5%. He also believes that the current P/E level reflects overvaluation of equities and should be adjusted by 2.5%.

Pon is also trying to estimate an appropriate equity risk premium. However, she believes that markets are moving towards perfect integration and that the beta of U.S. stocks relative to the MSCI World Index is 0.9265. She has also estimated the national and global risk-free rates to equal 4.3% and 5.7% respectively. She wonders how her belief will affect her estimate of equity risk premium relative to what Forman just estimated.

After estimating the equity risk premium, Forman is now estimating the beta for Ellen Designs (ELLED), a privately owned clothing outlet. Forman decides to use the beta of a public comparable to estimate the beta of ELLED. He determines the public peer’s beta to be 1.31. When Pon asked Forman about the procedure involved, Forman made the following comments:

Statement 3: “If the public peer has 20% more debt than ELLED, its equity beta will be 20% greater than the estimated beta for ELLED.”

Statement 4: “If ELLED has exactly the same amount of debt in its capital structure as its public peer, its estimated beta will exactly equal the equity beta of the public peer.”

As the last assignment of the day, Pon has to estimate the required return of a private business. For this, she first estimates an equity risk premium with reference to the S&P 500 index. She then adds the risk-free rate and a beta-adjusted size premium to this estimate, with the size premium estimate based on the lowest market-cap decile.

Question

Pon is most accurate with respect to

A.
Statement 1 only.
B.
Statement 2 only.
C.
both statements 1 and 2.

Question

With respect to their comments about the equity risk premium estimates based on the geometric and arithmetic mean, are Forman and Pon most likely correct?

A.
Only Forman is correct
B.
Only Pon is correct
C.
Both Forman and Pon are correct

Question

Using the information gathered by Forman, an estimate of the U.S. equity risk premium is closest to:

A.
5.24%
B.
4.69%
C.
5.09%

Question

Assuming that the U.S. equity risk premium is 4.75%, Pon will most likely use a:

A.
5.099% equity risk premium estimate and a 4.3% risk-free rate to obtain the required return estimate.
B.
5.127% equity risk premium estimate and a 4.3% risk-free rate to obtain the required return estimate.
C.
5.322% equity risk premium estimate and a 5.7% risk-free rate to obtain the required return estimate.

Question

Forman is most accurate with respect to: