"Equity Investments":Exponential weight

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Questions 1:

A company just paid an annual dividend of €1.25 per share. If the required annual rate of return is 14% and dividends are expected to grow indefinitely at a constant rate of 8%, the company’s intrinsic value per share is:

A 、€16.88.

B、 €20.83.

C、 €22.50.

Questions 2:

The index weighting that results in portfolio weights shifting away from securities that have increased in relative value toward securities that have fallen in relative value whenever the portfolio is rebalanced is most accurately described as:

A、 float-adjusted market-capitalization weighting.

B、 fundamental weighting.

C、 equal weighting.

View answer resolution

【Answer to question 1】C

【analysis】

C is correct. The value of the shares can be estimated using the Gordon growth model as follows:

Equity Investments:Exponential weight

A is incorrect because €16.88 is derived using the growth rate in the denominator of the formula instead of the difference between the required rate of return and the growth rate: V0 = €1.35/0.08 = €16.88

B is incorrect because €20.83 results from incorrectly using D0 (instead of D1) as the next period dividend: V0 = €1.25/0.06 = €20.83

【Answer to question 2】B

【analysis】

B is correct. Fundamentally weighted indexes generally will have a contrarian “effect” in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced.

A is incorrect. In the float-adjusted market-capitalization weighting scheme, the constituent securities whose prices have risen the most (or fallen the most) have a greater (or lower) weight in the index.

C is incorrect. In an equal weighting scheme, securities that constitute the largest fraction of the target market value are underrepresented and securities that constitute a small fraction of the target market value are overrepresented. This weighting scheme does not consider fundamental measures in rebalancing.

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