Question

QUESTION 4

4.1 ABC shares have had returns of 8 percent, -13 percent, -7 percent and 29 percent for four of the last 5 years.

4.1.1 If the average return of the share over this period is 11 percent, what was the share’s return for the missing year? (3)

4.1.2 What is the standard deviation of the share’s return? (6)

4.2 The Extreme Reaches Corp. last paid a R1.50 per share annual dividend. The company is planning on paying R3.00, R5.00, R7.50, and R10.00 a share over the next four years, respectively. After that the dividend will be a constant R2.50 per share per year. What is the current market price of this share if the market rate of return is 15%? (6)

4.3 Explain what it means for a company to have a current ratio of 0.50. Would the company be better off if the current ratio was 1.50? What if it was 15.0? Explain your answers. (5)

Answer 1

1: average return= sum of all the returns/number of observations

11% = (8%-13%-7%+29%+ R5)/5

55% = 17%+R5

R5 = 38%

2: standard deviation= SQRT(Sum (X-Average return)^2)/N-1)

= SQRT(((8%-11%)^2+(-13%-11%)^2+(-7%-11%)^2+(29%-11%)^2+(38%-11%)^2)/4)

= 22.15%

3: Current price = D1/(1+k)+ D2/(1+k)^2 + D3/(1+k)^3 (D4+P4) /(1+k)^4

P4 = D5/Rate = 2.5/15% = 16.66667

Current price = 3/1.15^1+ 5/1.15^2+ 7.5/1.15^3+ (10+16.67) /1.15^4

=$ 26.57

4: current ratio represents the ratio of current assets to current liabilities. This represents the liquidity position of the firm and its ability to meet its immediate liabilities. A current ratio of 0.5 implies that the business has half the assets to meet its immediate liabilities. Of current ratio of 1.5 implies that the business has 1.5 asset for every liability. A current ratio of 15 implies that for every dollar of liability, the firm has maintained $15.00 worth of assets. This implies that the company can reduce its current assets since investment in working capital is excessive.