a) Assume that, in order to pay off the debt (retire the junk bonds they’ve issued), these investment bankers need for the stocks they have bought to increase in value by at least 25%. Assume, as in Malkiel’s example on page 1317, “that the ‘riskless’ rate of interest on government bonds is 9% and that the required additional risk premium for equity investors is 2%” and that the next period’s dividend is $5. Assume, further, that initially, the expected growth rate of the current dividend is 1%.
By how much would the expected growth rate of the current dividend need to increase to generate the required 25% boost in the stock price? [Assume that next period's dividend remains $5.]
b) Explain how the equation and numerical example demonstrate that the phenomenon of apparent "undervaluation" is proof that markets are, indeed, efficient.