California Clinics, an Investor-Owned Chain of Ambulatory

California Clinics, an investor-owned chain of ambulatory care clinics, just paid a dividend of $2 per share. The firm's dividend is expected to grow at a constant rate of 5% per year, and investors require a 15% rate of return on the stock.

What is the stock's value?

PO = D 1 / ( KS - G )

P PO = Price

D1 = The next dividend. D1 = D0 (1 + G)

KS = Rate of Return

G = Growth Rate=D1/(Ks-G)

P = 2.10 / (15% - 5%)

P = $

Suppose the riskiness of the stock decreases, which causes the required rate of return to fall to 13%. Under these conditions, what is the stock's value?

P = 2.10 / (13% - 5%)

P = $26.25

Return to the original 15% required rate of return and assume a dividend growth rate estimate increase to 7% per year, what is the stock value?

= 2 * 1.07 = 2.14

P = 2.14 / (15% - 7%)

P = $26.75

4.

Explain how each of the four (4) fundamental factors that affect the supply and demand for investment capital, and hence, interest rates, (namely productive opportunities, time preferences for consumption, risk, and inflation) affects the cost of money.

Holding cash has a certain amount of expense related to it. That is, it is costly in a way to hold cash because there is a certain opportunity cost attached to it; the value of the cost is driven by several different factors. Productive opportunities represent one such factor because if production opportunities are plentiful then this puts upward pressure on the demand for capital and consequently also puts upward pressure on interest rates. Time preferences for consumption also affect the supply and demand for investment capital because if you are interested in consumption in the short-term then you value holding cash more thus driving up the cost of money.

Risk also affects the cost of money. If there is little risk, such a treasury bill or government bond, then there is very little interest paid on this type of investment. The greater the amount of risk, the less likely anyone would be to lend and consequently they would demand a greater rate of return or interest payment on their investment. Inflation also affects the cost of money. If there is low inflation then money doesn't depreciate as quickly in periods of higher inflation. Thus the opportunity cost of holding cash is lower in periods of low inflation. In periods of high inflation, the cost of holding cash is greater because the value depreciates faster.

4. Why is risk aversion so important to financial decision making?

Risk aversion is critical to financial decision making because the amount of risk, to some extent, dictates the rate of return. Therefore, some amount of risk is healthy if you seek higher returns than a risk free rate. However, if you accept too much risk then you could also potentially lose out completely. The key is to accept risk, so that you can achieve profitability, but to also diversify the risk so that not all your eggs are in one basket.

5. Explain the three (3) techniques for solving time value problems.