Week 4 Risk And Return: 3-4 Paragraphs From The E-Activity

Week 4risk And Return 3 4 Paragraphs From The E Activity Determine

Determine whether stock prices are affected more by long-term or short-term performance. Provide one example of the effect that supports your claim. From the scenario, value a share of TFC’s stock using a growth model method and compare that value to the current trading price of a share of TFC. Determine whether the stock is undervalued or overvalued. Provide a rationale for your response.

Paper For Above instruction

Stock prices are influenced by a combination of short-term market sentiments and long-term fundamental performance, but their sensitivity to these factors varies depending on market conditions and investor perspectives. Evidence suggests that short-term performance often impacts stock prices more immediately due to news events, earnings reports, and macroeconomic developments. For example, a sudden quarterly earnings miss can lead to a rapid decline in stock prices, reflecting investor reactions to the company's short-term financial health. Conversely, long-term performance influences stock prices through sustained growth trajectories, strategic positioning, and overall economic stability, which tend to affect valuations more gradually. In a volatile market, short-term influences tend to dominate stock price movements, while in stable markets, long-term fundamentals become more significant.

Using a growth model, such as the Gordon Growth Model (Dividend Discount Model), the value of TFC's stock can be estimated based on expected dividends and a required rate of return. Assume TFC is expected to pay a dividend of $3 per share next year, with dividends expected to grow annually at a rate of 5%, and the required rate of return is 10%. The intrinsic value (P) can be calculated as: P = D1 / (r - g) = $3 / (0.10 - 0.05) = $3 / 0.05 = $60. Comparing this estimated intrinsic value to TFC's current trading price of $55 indicates that the stock is undervalued, suggesting a potential buying opportunity. The undervaluation may be attributed to market overreaction or short-term market conditions that temporarily depress the stock price, while the intrinsic valuation based on long-term fundamentals points to a higher fair value.

Analysis of Methods of Creating a Risk-Free Hedge Portfolio and WACC

To create a risk-free hedge portfolio using stocks and options, investors can utilize methods such as covered calls, protective puts, and long-short strategies. The covered call approach involves holding a long position in the stock while selling call options against it. This strategy generates income from option premiums, providing partial downside protection if the stock declines, while capping upside potential. For example, an investor holding shares of TFC might sell call options at a strike price slightly above the current market price, collecting premiums that serve as a buffer against stock drops.

Another method is the protective put strategy, where an investor holds the underlying stock and buys put options. The purchased puts act as insurance against significant declines, ensuring a minimum sale price for the stock. For instance, buying puts with a strike price near the current stock value guarantees limited downside risk. A third approach involves creating a long-short equity position, where the investor simultaneously takes a long position in a stock expected to outperform and a short position in a correlated stock expected to underperform, effectively hedging market risk. These methods, when properly executed, can combine to form a synthetic risk-free hedge, reducing overall portfolio exposure to market volatility.

Considering the scenario, a hypothetical WACC for TFC might be calculated with the following assumptions: the cost of equity estimated at 12% (using the Capital Asset Pricing Model), the cost of debt at 5% with a corporate tax rate of 21%, and the capital structure comprising 60% equity and 40% debt. The WACC calculation would be: WACC = (E/V Re) + [(D/V Rd) (1 - Tc)] = (0.60 12%) + (0.40 5% (1 - 0.21)) = 7.2% + 1.58% = approximately 8.78%. Based on this WACC, the company’s rate of return on potential investments should exceed this threshold to create value. Given this threshold, if the projected return on expansion initiatives is estimated at 10%, the company should proceed, as the investment would generate returns above the WACC, thus creating value for shareholders. Conversely, if returns are below this rate, expansion should be reconsidered to avoid value destruction.

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