Question

(a) The following table provides information about two NZX listed companies, A Ltd and B Ltd, with some missing entries:

	A Ltd	B Ltd
Actual return in share price for the current year	0.095	0.065
Expected return in share price for the current year	?	?
Abnormal return in share price for the current year	0.00645	?
Market model equation	E(R) = 0.033 + 1.010 × Rm	?

Two analysts provide the following  market model equations for B Ltd, respectively:

Analyst X:        E(R) = 0.025 + 1.110 × Rm

Analyst Y:         E(R) = 0.042 + 0.098 × Rm

Where:

• E(R) is the expected return in share price for the company for the current year; and

• Rm is the market return in share price for the current year.

REQUIRED:

1. Calculate the expected return in share price for A Ltd for the current year. Show your workings.

2. Using the market models provided by Analyst X and Y, calculate the expected return in share price for B Ltd for the current year respectively. Show your workings.

3. Using the market models provided by Analyst X and Y, calculate the abnormal return in share price for B Ltd for the current year respectively. Show your workings.

4. If forecast errors in EPS for the current year for B Ltd is $0.05, based on your calculations above and referring to the information theory, briefly explain which analyst’s market model equation you agree with. (Maximum words: 100)

Answer 1

	A Ltd	B Ltd
Actual return in share price for the current year	0.095	0.065
Expected return in share price for the current year
Abnormal return in share price for the current year	0.00645
Market model equation	E(R) = 0.033 + 1.010 × Rm

1)

Abnormal return in share price for the current year = Actual return in share price for the current year - Expected return at share price for the current year

Expected return in share price for A for the current year = 0.095-0.00645 = 0.08855

Expected return at share price for A for the current year E(R) = 0.033 + 1.010 × Rm

0.033 + 1.010 × Rm = 0.08855

Return on the market Rm = 0.055

2)

Analyst X:        E(R) = 0.025 + 1.110 × Rm

E(R) = 0.025 + 1.110 × 0.055 = 0.08605

Analyst Y:         

E(R) = 0.042 + 0.098 × 0.055 = 0.04739

3)

Abnormal return in share price for the current year = Actual return in share price for the current year - Expected return at share price for the current year

Analyst X Abnormal returns for Stock B = 0.065-0.08605 = -0.02105

Analyst Y Abnormal returns for Stock B = 0.065-0.04739= 0.01761

4)

The expected return for both analysts is based on various assumptions related to the beta of the stock. In this case, the forecasted EPS might have a bearing on the expected returns by these analysts. The forecast errors in EPS is $0.05. In this case, it is prudent and conservative to believe in the analyst's market model equation which has the least expected return and abnormals returns. Here, we observe that Analyst Y has expected return for stock B to be lower than Analyst A. Also, the abnormal returns is lesser for Analyst Y. Hence, Analyst Y's is more agreeable if the forecasted EPS has an error of $0.05.