Question

You are analyzing the U.S. equity market based upon the S&P Industrials Index and using the present value of free cash flow to equity technique. Your inputs are as follows:

Beginning FCFE: $80
k = 0.07
Growth Rate:
Year	1–3:	7%
	4–6:	6%
	7 and beyond	5%

1. Assuming that the current value for the S&P Industrials Index is 4,200, would you underweight, overweight, or market weight the U.S. equity market? Do not round intermediate calculations. Round your answer to the nearest cent.

   You should -Select-underweightoverweightmarket weightItem 1 the U.S. equity market as the estimated value of the stock of $   is -Select-higher thanlower thanequal torItem 3 the S&P Industrials Index.

2. Assume that there is a 1 percent increase in the rate of inflation — what would be the market’s value, and how would you weight the U.S. market? Assume that the required return would increase from 7% to 8%, decreasing the value. Also assume that the nominal cash flow growth rates would increase for all time periods by one percentage point. Do not round intermediate calculations. Round your answer to the nearest cent.

   You should -Select-underweightoverweightmarket weightItem 4 the U.S. equity market as the estimated value of the stock of $   is -Select-higher thanlower thanequal torItem 6 than the S&P Industrials Index.

Answer 1

1.
=80*(1.07/1.07)+80*(1.07/1.07)^2+80*(1.07/1.07)^3+80*(1.07/1.07)^3*(1.06/1.07)+80*(1.07/1.07)^3*(1.06/1.07)^2+80*(1.07/1.07)^3*(1.06/1.07)^3+80*(1.07/1.07)^3*(1.06/1.07)^3*1.05/(7%-5%)
=4558.88200

You should overweight the U.S. equity market as the estimated value of the stock of $4558.88200 is higher than the S&P Industrials Index.

2.
=80*(1.08/1.08)+80*(1.08/1.08)^2+80*(1.08/1.08)^3+80*(1.08/1.08)^3*(1.07/1.08)+80*(1.08/1.08)^3*(1.07/1.08)^2+80*(1.08/1.08)^3*(1.07/1.08)^3+80*(1.08/1.08)^3*(1.07/1.08)^3*1.06/(8%-6%)
=4598.89232

You should overweight the U.S. equity market as the estimated value of the stock of $4598.89232 is higher than the S&P Industrials Index.