Financial Economics Assignment 02

Name: Hopkins ID:

Professor Nan Zhou

For this assignment, you will be analyzing two stocks of your choice. Yahoo Finance is a useful source for the data that
you will need.

The two stocks I chosen to report are:

a) LARGAN Precision Co.,Ltd (3008.TW) and
b) Foxconn Technology Co., Ltd. (2354.TW)
We will use LARGAN to represent LARGAN Precision and Foxconn to represent Foxconn Technology. All the
statistics are reported on February 21, 2020, in New Taiwan Dollars or in percentages, and all calculations are
with 2 decimal places of precision.

1. (30) We begin by breaking down the prices of these stocks using the dividend discount growth model.
(a) (10) Report the stock price and book value per share, alongside the forecasted dividend and earnings per
share, using any reasonable estimate. Going by these statistics, which of your stocks looks more like an
income stock and which looks more like a growth stock?

February 21, Closed Price Book Value per Share Forecasted Dividend Diluted Earnings
2020 (mrq) per Share (ttm)
LARGAN 4,740.00 884.78 68 197.00
Foxconn 60.50 70.99 3.2 6.34
By looking at the price to book value (LARGAN: 5.36; Foxconn: 0.85), the dividend yield (LARGAN: 1.43%;
Foxconn: 5.29%) of both stocks, Foxconn is more like an income stock while LARGAN is more a growth
stock.

(b) (10) For each stock, calculate the payout ratio and return on book equity, and compute the growth rate that
this implies.

We calculate the payout ratio and return on book equity based on diluted EPS and forecasted dividend,
where:
Dividend Diluted EPS
Payout Ratio= , ROE= ,
Diluted EPS Book Value per Share
growthrate=( 1− payout ratio )∗ROE
February 21,
Payout Ratio Plowback Ratio ROE Growth Rate
2020
 68 68 197.00
LARGAN =0.3452 1− =0.6548 =0.2227 0.6548∗0.2227=0.1458
197.00 197.00 884.78
3.20 3.20 6.34
Foxconn =0.5047 1− =0.4953 =0.0893 0.4953∗0.0893=0.0442
6.34 6.34 70.99
(c) (10) For each stock, calculate the market capitalization rate, and break down the share price into the level
earnings and growth opportunities components.

EP S 1
Share price= +PVGO , where PVGO is the growth opportunities components, and EPS1 is
r
assumed constant.

DI V 1 EP S 1
Market Capotalization Rate= + g Share Price PVGO
P0 r
68 197.00
r LARGAN = +0.1458=0.1601 4,740.00 =1,230.4809 3509.5190
4740.00 0.1601
3.2 6.34
r Foxconn= +0.0442=0.0971 60.50 =65.2935 −4.7935
60.5 0.0971

2. (30) For the sake of simplicity, assume that in each year, each company has a single investment opportunity to
plow back some percentage of its earnings to generate annual cash flows at a rate equal to the its current return
on book equity.
(a) (10) For each company, consider the investment opportunity available next year (t = 1). Calculate the
payback period, internal rate of return, and net present value NPV1 of next year’s investment opportunity.
Are these projects worth pursuing?

LARGAN Foxconn
Reinvest 0.6548∗197.00=128.9956 0.4953∗6.34=3.1402
Annual cash inflow 128.9956∗0.2227=28.7273 3.1402∗0.0893=0.2804
128.9956 3.1402
Payback period ⌈ ⌉ =5 ⌈ ⌉=12
28.7273 0.2804
28.7273 0.2804
Internal rate of return =0.2227>r LARGAN =0.0893<r Foxconn
128.9956 3.1402
28.7273 0.2804
NPV1 −128.9956+ =50.4379 −3.1402+ =−0.2525
0.1601 0.0971
Denote that:
Ri=reinvest ; Pr= plowback ratio ; C=annual cash inflow ; r =market capitalization rate
 Reinvest
Ri=Pr∗EPS , C=Ri∗ROE , payback period=⌈ ⌉ ,
Annual cash inflow
C C
IRR= , NPV 1=−Ri +
Ri r
By our computation, we found that LARGAN’s investment has a positive NPV at t=1, and of course the IRR is
larger than the cost of equity, so the project LARGAN facing is worth pursuing. However, Foxconn
shouldn’t consider doing the investment because the return will be less than investors’ demand, which
means that instead of doing this not-profitable-enough investment, Foxconn should payout its earning to
investors and let them do their own investment; Foxconn’s project is a no go.

(b) (10) Now consider each company’s investment opportunity at t = 2, with annual earnings permanently
increased by the cash flows from the year 1 investment. If the firm continues to plow back the same
proportion of earnings and earns the same return on equity, what is the net present value NPV2 of the
project?

(2−1)
NPV 2=NP V 1∗( 1+ g )

NP V 2 LARGAN
=50.4379∗1.1458 1=57.7917
1
NPV 2 Foxconn=−0.2525∗1.0442 =−0.2637

(c) (10) If each company continued to plow back earnings at the same rate and earn the same return on equity,
what would be the present value of all its future growth opportunities? Does this match your answer from
#1?

NP V 1 EP S1
PVGO= , P 0= + PVGO
r−g r
197.00 50.4379
P0LARGAN = + =4,757.61
0.1601 0.1601−0.1458
6.34 −0.2525
P0Foxconn = + =60.52
0.0971 0.0971−0.0442
The computed present values of both stocks deviate from their actual prices with less than 1% errors, I will
say the present values match the reported stock prices very well.

3. (40) We will now analyze the historical returns of your chosen stocks. You may choose any time period and
frequency you deem suitable, but make sure that all of your returns are reported as annualized rates. You will
want to use the adjusted closing price to automatically account for the effects of dividends and splits.
Both LARGAN and Foxconn are exchanged in Taiwan stock market, so our market index is TSEC weighted index
(^TWII). Also, we use n=52 to annualize the weekly returns.
We use weekly adjusted closed prices, from Feb. 11th, 2019 to Feb 17th, 2020 to calculate weekly returns which
then annualized.

(a) (10) For each stock as a well as a suitable market index, report the mean and standard deviation of returns.
TSEC LARGAN Foxconn
~r 0.1466 0.2012 0.0514
~
s 0.1119 0.2952 0.2059
r

(b) (10) Find the variance-covariance matrix of the two stocks and the market index, and report the beta of
each stock.

Variance-Covariance TSEC LARGAN Foxconn

TSEC 0.0125 0.0184 0.0167
LARGAN 0.0184 0.0872 0.0252
Foxconn 0.0167 0.0252 0.0424

σℑ Cov ( stock , market )

Where β i= 2
=
σ m
Var ( market )
Stock \ index TSEC LARGAN Foxconn
0.0125 0.0184 0.0167
β =1 =1.472 =1.336
0.0125 0.0125 0.0125

(c) (10) We now consider the benefits of diversifying by constructing a portfolio consisting of both of your
stocks. For each value of x = {0,0.1,0.2,...,1}, consider a portfolio with a proportion x of your wealth invested
in your first stock and 1−x invested in the second, and compute the mean and standard deviation of the
portfolio return.

The portfolio mean return: x∗~r LARGAN + ( 1−x )∗~r Foxconn

 x∗( 1−x )∗ρxy∗~s LARGAN ∗~s Foxconn
The portfolio volatility: 2
x 2∗~s 2LARGAN + ( 1−x ) ∗~s2Foxconn +2∗¿
x ~
rm ~
sm
0.0000 0.051435713 0.0424
0.1000 0.07155904 0.0444
0.2000 0.091682368 0.0472
0.3000 0.111805696 0.0509
0.4000 0.131929024 0.0550
0.5000 0.152052351 0.0597
0.6000 0.172175679 0.0647
0.7000 0.192299007 0.0700
0.8000 0.212422335 0.0756
0.9000 0.232545662 0.0813
1.0000 0.25266899 0.0872

(d) (10) Assume a risk free rate of rf = 0.01. In a well-diversified portfolio, only market risk matters, so the risk
premium of any stock should be proportional to its beta. If this were true, what should be the returns you
expect to earn from your two stocks, and how does this compare to their historical averages?

π i=ŕ i−ŕ f
We define risk premium as , and thus the market risk premium
π m=0.1466−0.01=0.1366
If the risk premium of any stock should be proportional to its beta, then the expected returns of any stock
should be:

E [ ~r i ]=ŕ f + β i∗(ŕ m−ŕ f )

LARGAN and Foxconn should be as below:

E [ ~r LARGAN ]=0.01+1.472∗( 0.1466−0.01 ) =0.2111

 E [ ~r Foxconn ] =0.01+1.336∗( 0.1466−0.01 )=0.1925
The risk premium-based expected return of LARGAN is a decent approximation of its historical average
within a rolling year ( ~
r LARGAN =0.2012 ). However, Foxconn’s expected return, 0.1925, deviates far
from its 1-year average return, 0.0514, which we should interpret this as: the investors who hold Foxconn
have born too much risk to earn too low return.