Midterm; F5360; Spring, 1994; page 1 of 2 Name



Midterm; F5360; Summer, 1994; page 1 of 2

1. Provide a short answer to each of the following:

a. Sketch a graph of the best risk/return possibilities obtainable by combining the feasible set with riskless borrowing and lending. Also discuss what movement along this line accomplishes.

b. Why would investors be more concerned with real returns that nominal returns?

c. What is the danger in using historical data to estimate the beta of an asset you are considering investing in?

d. Discuss who theoretically protects society’s interests when these interests come into conflict with those of the stockholders of a firm and why this protection might fail to materialize. (Note: I am looking for the underlying reason for the failure not specific examples of a failure or of why the failure might occur)

e. What conditions must occur in order for us to actually earn the yield to maturity on a bond?

2. You have just been hired by the owner of Backwoods Inn, Inc. For years, the firm has based expansion decisions on average return on book value. Discuss with your boss why he should base expansion decisions on net present value instead.

3. Assume that you will have income this year of $3500 and income next year of $5000. Assume also that your bank has informed you that for the next year, you may either borrow or lend at 9% per year. Finally, assume that you have determined that you should optimally invest $2000 in real assets and that this real investment will pay off $3000 one year from today and that you would like to consume $6000 one year from today.

a. Graph your income, optimal real investment, and all consumption possibilities both before and after your real investment.

b. Given your desire to consume $6000 one year from today, calculate and show graphically you greatest possible consumption this year?

c. Calculate and show graphically the impact on your wealth of the real investment.

d. Suppose that just before you undertake your investment in real assets, you call your banker one last time, and he informs you that interest rates have just dropped to 4.5% (for either borrowing or lending). Are you better off or worse off?

4. Suppose that the current one-year rate of interest is 5.08% and that the current two-year rate of interest is 5.82%. Also assume that the inflation risk hypothesis is correct?

a. What is the forward rate for the second year?

b. What is your best estimate of what the one year rate of interest will be one year from today?

c. Explain the rationale behind the relationship between your answers in part a and part b.

d. What kind of transaction would you undertake in order to earn the rate in part a?

e. What kind of transaction would you undertake in order to earn the rate in part b?

5. You have calculated the following information:

The expected return on Picard Leadership Training Inc. is 14%

The expected return on the Federation Academy Inc. is 8%.

The expected return on the S&P 500 is 13%

The return on Treasury bills is 5%

The standard deviation of returns on Picard Leadership Training Inc. is 18%

The standard deviation of returns on the Federation Academy is 7%.

The standard deviation of returns on the S&P 500 is 13%

The correlation between Picard Leadership Training and the S&P 500 is 0.88.

The correlation between the Federation Academy and the S&P 500 is 0.62.

a. Construct an arbitrage portfolio with Picard. Be sure to demonstrate that all of the conditions of arbitrage are satisfied.

b. How will this arbitrage affect Picard, the S&P 500, and Treasury bills?

Midterm; F5360; Summer, 1994; page 2 of 2

6. Your firm, Klingon Publishing Inc., is considering building a new printing facility in order to meet excess demand. You have estimated that construction costs for the plant will be $500,000 today and $100,000 per quarter beginning 2 months from today and continuing for 8 quarters. You have estimated that net monthly cash flows will begin 6 months from today. The first such inflow is estimated to be $10,000 and each subsequent cash flow is expected to increase by 1% (above the previous month) through 10 years from today. In addition, 10 years from today, you expect to incur closing costs of $150,000. If the required return on the plant is 8% per year compounded quarterly, should the plant be built?

Check Figures:

1. a. graph of feasible set, rf, tangency at M; discussion of adjusts risk/return to match preferences; b. consumption rather than $; c. reflect future?; d. gov’t, has own interests; e. hold to maturity; flat, stable yield curve; no default

2. main points: based on accounting values, ignores timing, ignores risk; npv measures impact on firm value

3. b. 3334.86; c. 752.29; better off

4. a. 6.565%; b. < 6.565%; c. main points: 1-year rate compensates for inflation over next year, 2-year rate compensates for inflation over next 2 years, unexpected inflation more likely over 2-year horizon => real return on 2-year investment riskier => 2-year interest rate contains premium => forward rate > expected future spot rate; d. buy 2-year bond and hold for 2 years; e. wait until next year then buy 1-year bond

5. a. XPicard = -1, XM = 1.2185, Xrf = -.2185; restore equilibrium by decr. price of Picard, increase (a little) price of market, decrease (a little) price of risk free asset

6. Build since NPV = 40818.05 > 0

Final; F5360; Summer, 1994; page 1 of 2

1. Provide a short answer to each of the following:

a. You have just exercised a put option on IBM stock with an exercise price of $75. What have you done?

b. The variance of returns on the stock of WSJ Inc. has just declined, what has happened to the value of the option that you own on WSJ?

c. What is the basic “intuition” behind Modigliani and Miller’s capital structure irrelevance argument?

d. What tradeoffs must we consider when deciding on a sample size with which to estimate an asset’s beta?

e. What is a forward rate?

2. Why might capital budgeting decisions based on the project’s payback period fail to maximize stockholder wealth?

3. For lack of anything better to do, Digital Oatmeal Inc. has decided to get into the fashion design business (something about it being the perfect fit). Digital’s management has estimated the cash flows from such an enterprise, but are unsure of what discount rate to use in analyzing the project. Your boss had just dumped the following information on your desk and asked you what to figure out what rate they should use.

Firm Debt Beta Equity Beta %Debt

Quaking Oats Inc. 0.2 1.4 40

Kalv Incline Fashions Inc. 0.4 1.2 55

Keltic Klog Cereals Inc. 0.1 0.8 10

Dizzy Claymore Fashion Design Inc. 0.3 1.9 60

Johan Strauss & Co. (a fashion co.) 0.2 1.1 30

United Postal Cereal Inc. 0.5 1.5 40

The return on Treasury bills is 4.5% per year.

The expected return on the Standard and Poor’s 500 is expected to be 12% per year for the foreseeable future.

4. What have studies on market efficiency concluded about whether some investors have information not reflected in stock prices? (Be sure to give as complete an answer as possible).

5. Losing Record Pennant Winner, Inc. has always paid out a dividend that is 2% larger than the previous year’s dividend on the hopes that a steadily increasing dividend will maximize the value of the firm’s stock. This year, after undertaking all the worthwhile projects available to the firm, the firm has no excess cash with which to pay the dividend. Considering only the impact of taxes and assuming that Winner does not want to change its capital structure, discuss why might Winner wish to omit this dividend? (Note: a numerical example might be helpful).

6. Suppose that your firm, Brazil Elbow Macaroni Inc. makes funding and capital structure decisions solely on the basis of Modigliani and Miller’s theory of capital structure including corporate taxes; however, based on discussions with you around the lunch table, you boss is now convinced that funding and capital structure decisions should be made solely on the basis of how capital structure can be used to reduce stockholder/manager conflicts. How would funding decisions differ under the new policy guidelines? Be sure to explain the rationale behind your answer.

7. You are considering purchasing a $1000 par bond that matures 8 years and 3 months from today. The coupon on this bond is $55 per year paid semiannually. If the required return on this bond is 8% per year, under what conditions would you be willing to purchase this bond?

Final; F5360; Summer, 1994; page 2 of 2

8. USA USA USA usa Soccer Inc. currently has assets with a market value of $15,000. Soccer is planning to undertake a project that would require an immediate outlay of $2000 and would provide a cash inflow of $200 per year for 25 years with the first inflow occurring 2 years from today. The required return on this project is 7% per year. The firm currently has debt outstanding that matures in 3 years for $14,000. The current project would be funded with $500 in cash, a debt issue with a face value of $1000, and an equity issue. After the project is undertaken, the standard deviation of returns on the firm’s assets will be 43%. The risk free rate of interest is 5%.

a. What is total value of the firm’s equity after the investment?

b. What is value of the debt that is issued?

c. How much equity will Soccer have to issue?

Check figures:

1. a. sold IBM stock for $75 per share; b. dropped; c. doesn’t affect firm value since splitting CF affects neither risk nor level of CF; d. decrease sample error, increase chance of structural shift; e. implied future rate if undertake LT investment today

2. main points: ignores timing, risk, and cash flow beyond payback, also no criteria always max. S/H wealth

3. 10.825%

4. main points: corporate insiders have superior information, unclear whether professional investment managers have superior information (likely not), value line rankings and analysts surveyed in “Heard on Street” have suprior info

5. Main points: must either cut investment in positive NPV projects or issue stock => loss if issue stock: taxes on dividends; loss if cut investment : taxes on dividends and forgone positive NPV

6. Before change: 100% debt: After: growth => still have some debt, but < 100% (allows concentration of ownership in mgt’s hands); mature => heavily funded with debt, but < 100% (concentration of ownership, distribute discretionary CF)

7. price < 873.07

8. a. 6445.13; b. 682.21; c. 817.79

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download