Chapter 8: 4. There are two reasons that the indexes can move in opposite directions. First, since the DJIA includes only the largest stocks, these can do better or worse than the 470 addition (albeit smaller) stocks in the S&P 500. Second, since the DJIA is a price-weighted index and the S&P 500 is value weighted, they can move in opposite directions as a consequence of the fact that stocks with a high market capitalization might move in the opposite direction from those with low market capitalization, but the price movement could be smaller. 5. If the price is $100: EMBED Equation.3 rp=2.5% The risk premium is lower than the historical average of 4%. If the price is $150: EMBED Equation.3 rp=1.17% The risk premium is much lower than the historical average of 4%. 7. Year 1: Revenue=$200 Profit=$200-10%*($800)=$120 Year 2: Revenue=$100 Profit=$100-10%*($800)=$20 Revenue falls by 50%; profits fall by 83% Year 1 Return to Stockholders=$120/$200=60% Year 2 Return to Stockholders=$20/$200=10% 8. If D=$5, rf=3.5%, g=2%, and rp=4%, then EMBED Equation.3 If rp falls to 2%, then EMBED Equation.3 Because changes in the risk premium have such a large impact on the prices of stocks, recent history is not a very good predictor of future stock returns. 11. EMBED Equation.3 On June 2, 2004, the S&P 500 was at 1124.99. This suggests either that stocks in the index are undervalued, or that that the equity risk premium is positive.
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