Quesba



Question 1: Agency problem

a. What are the major of functions of the financial manager?

b. What are the factors that affect the market value of a firm’s common stock?

c. What are the disadvantages of profit maximization and stockholder wealth maximization as the goals of the firm?

Question 2: Decision tree

A firm has an opportunity to invest in a machine which will last 2 years, initially cost $125,000, and has the following estimated possible after-tax cash inflow pattern: year 1, there is a 40 percent chance that the after-tax cash inflow will be $45,000, a 25 percent chance that it will be $65,000, and a 35 percent chance that it will be $90,000. In year 2, the after-tax cash flow possibilities depend on the cash inflow that occurs in year 1; that is, the year 2 cash flows are conditional probabilities. Assume that the firm’s after-tax cost of capital is 12 percent. The estimated conditional after-tax cash inflows and probabilities are given below.

|If After-tax cash flow at year 1 = $ 45,000 |If After-tax cash flow = $ 65,000 |If After-tax cash flow = $ 90,000 |

|If After-tax cash flow |Probability |If After-tax cash flow |Probability |If After-tax cash flow |Probability |

|at year 2 = $ 45,000 | |at year 2 = $ 65,000 | |at year 2 = $ 90,000 | |

|30,000 |0.3 |80000 |0.2 |90000 |0.1 |

|60,000 |0.4 |90000 |0.6 |100000 |0.8 |

|90,000 |0.3 |100000 |0.2 |110000 |0.1 |

a. Drawing out the decision tree which shows the possible after-tax cash inflow in each year?

b. Calculating the expected NPV, which is the weighted average of the individual path NPVs where the weights are path probabilities?

Question 3: The lease – purchase decision

A firm has decided to acquire an asset costing $100,000 that has an expected life of 5 years, after which the asset is not expected to have any residual value. The asset can be purchased by borrowing or it can be leased.

If leasing is used, the lessor requires a 12 percent return. As is customary, lease payments are to be made in advance, that is, at the end of the year prior to each of the 10 years. The tax rate is 50 percent and the firm’s cost of capital, or after-tax cost of borrowing, is 8 percent.

If the asset is purchased, the firm is assumed to finance it entirely with a 10 percent unsecured term loan. Straight-line depreciation is used with no salvage value. Therfore, the annual depreciation is $20,000 ($100,000/5).

Suppose that you are entitled to decide a way to use the asset, leasing or buying the asset, which one you can choose?

Question 4: CAPM and APT

a. Differentiate the CAPM and APT?

b. During a 5-year period, the relevant results for the aggregate market are that the rf (risk-free rate) is 8 percent and the rm (return on market) is 14 percent. For that period, the results of four portfolio managers are as follows:

|Portfolio Manager |Average Return (%) |Beta |

|A |13 |0.80 |

|B |14 |1.05 |

|C |17 |1.25 |

|D |13 |0.90 |

i. Calculate the expected rate of return for each portfolio manager and compare the actual returns with the expected returns.

ii. Based on your calculations, select the manager with the best performance.

iii. what are the critical assumptions in the capital asset pricing model (CAPM)? What are the implications of relaxing these assumptions?

c. Suppose a three-factor APT holds and the risk-free rate is 6 percent. You are interested in two particular stocks: A and B. the returns on both stocks are related to factors 1 and factors 2 as follows: r = 0.06 + b1(0.09) – b2(0.03) + b3(0.04)

The sensitivity coefficients for the two stocks are given below:

|Stock |b1 |b2 |b3 |

|A |0.70 |0.80 |0.20 |

|B |0.50 |0.04 |0.20 |

Calculate the expected returns on both stocks. Which stock requires a higher return?

Question 5: Risk and returns of portfolios

The spreadsheet that comes with this assignment includes price data for 10 American stocks and the S&P 500.*

For all 10 stocks:

|Date |IBM |Cisco |

| | |CSCO |

|Total earnings |$3,000 |$1,100 |

|Shares outstanding |600 |400 |

|Price per share |$70 |$15 |

Firm A is acquiring Firm B by exchanging 100 of its shares for all the shares in B. What is the cost of the merger if the merger firm is worth $63,000? What will happen to Firm A’s EPS? Its PE ratio?

* Yahoo does not report the dividend-adjusted returns for the S&P. Therefore we have used the market prices for Vanguard’s S&P 500 Index fund as a proxy for the S&P.

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