FNCE 370v8: Assignment 4

FNCE 370v8:
Assignment 4

Assignment 4 is worth 5% of your final mark.
Complete and submit Assignment 4 after you complete Lesson 12.

There
are 12 questions in this assignment. The break-down of marks for each question
is presented in the table below. Please show all your work as this will help
the marker give you part marks as well as serve as a good study aid as you
prepare for the Final Examination.

Question

Marks Available

Reference

1

5

Lesson 10

2

5

Lesson 10

3

5

Lesson 10

4

5

Lesson 10

5

10

Lesson 11

6

15

Lesson 11

7

10

Lesson 11

8

10

Lesson 11

9

5

Lesson 12

10

10

Lesson 12

11

10

Lesson 12

12

10

Lesson 12

Total

100

1.
Explain the interactions among market
efficiency, capital budgeting, and the cost of capital. (5 marks)

2.
(5 marks)
a.
Give two examples of anomalies in the
financial markets.

b.
What does the existence
of these anomalies say about financial market efficiency?

3.
You bought one of BB Co.’s 9% coupon bonds
one year ago for $1020. These bonds make annual payments and mature six years
from now. Suppose you decide to sell your bonds today, when the required return
on the bonds is 10%. If the inflation rate was 4.2% over the past year, what
would be your total real return on investment?
(5 marks)

4.
The returns on XYZ Corp. over the last four
years are 10%, 12%, 3%, and -9%.
(5 marks)

What is the historical average return over the
last four years?

What is the variance of the returns over the last
four years?

What is the standard deviation of the returns
over the last four years?
5.
(10 marks)
a.
Suppose we have two assets, A and B. What
correlation levels between the two assets will yield diversification benefits
in terms of portfolio risk reduction?

b.
At what correlation
level will there be no diversification benefits in terms of portfolio risk
reduction?

c.
Will there be any
diversification benefits in terms of portfolio risk reduction in the case when
the correlation between the two assets’ returns is -1?

6.
(15 marks)
The expected
returns, return variances, and the correlation between the returns of four
securities are shown below.

Security

Expected Return

Variance of Returns

Correlation

A

B

C

D

A

0.17

0.0169

1.0

0.4

0.7

0.2

B

0.13

0.0361

1.0

0.6

0.5

C

0.09

0.0049

1.0

0.9

D

0.07

0.0050

1.0

a. Determine the expected return and variance for a
portfolio composed of 25% of security A and 75% of security B.

b. Determine the expected return and variance of a
portfolio that contains 78% security A and 22% security B. Is this portfolio
superior to that one in (a) above?

c. Calculate the expected return and variance of a
portfolio that contains 60% security C and 40% security D.

d. If an investor were to select among the following
three portfolios, which one would he or she prefer?

o
An
equally-weighted portfolio of securities A, B, and C.

o
An
equally-weighted portfolio of A, B, and D.

o
An
equally-weighted portfolio of B, C, and D.

e. If a risk-adverse investor desires to hold a
portfolio of only two securities and expects a return of 11%, what would you
advise the investor to do?

7.
Use
the following information to answer the questions below. (10 marks)

Security

Return

Standard Deviation

Beta

A

15%

8%

1.2

B

12%

14%

0.9

a.
Which
of A and B has the least total risk? The least systematic risk?
b.
What
is the value of systematic risk for a portfolio with 75% of the funds invested
in A and 25% of the funds invested in B?
c.
Calculate
the risk free rate of return and the market risk premium
(i.e., Rf and RM – Rf).
d.
What
is the portfolio expected return and the portfolio beta if you invest 30% in A,
30% in B, and 40% in the risk-free asset?
(For questions (d) and (e), assume the risk free rate of return is 5%.)
e.
What
is the portfolio expected return with 125% invested in A and the remainder in
the risk-free asset via borrowing at the risk-free interest rate?
f.
What
is the beta of the portfolio created in part (e)?

8.
Consider the following information on three
stocks. (10 marks)

Rate of Return if State Occurs

State of economy

Probability of
state of economy

Stock A

Stock B

Stock C

Boom

0.5

0.2

0.35

0.6

Normal

0.3

0.15

0.12

0.05

Bust

0.2

0.01

-0.25

-0.5

a.
If your portfolio is
invested 40% each in A and C, and 20% in B, what is the portfolio expected
return?

b.
What is the variance of
this portfolio?

c.
What is the standard
deviation of this portfolio?

d.
If the expected T-Bill
rate is 5%, what is the expected risk premium on the portfolio?

e.
If the expected
inflation rate is 2.50%, what are the approximate and exact expected real
returns on the portfolio?

f.
If the expected T-Bill
rate is 5% and the expected inflation rate is 2.50%, what are the approximate
and exact expected real risk premiums on the portfolio?

9.
Briefly discuss the
advantages and disadvantages of using the dividend growth model to estimate the
cost of equity. (5 marks)

10.Mustard
Patch Doll Company needs to purchase new plastic moulding machines to meet the demand
for its product. The cost of the equipment is $100,000. It is estimated that
the firm will generate, after tax, operating cash flow (OCF) of $22,000 per year
for the next seven years. The firm is financed with 40% debt and 60% equity,
both based on market values. The firm’s cost of equity is 16% and its pre-tax
cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%,
respectively. Assume the firm’s tax rate is 34% and ignore the effects of CCA
depreciation. (10 marks)

a. What is
the firm’s tax adjusted WACC?

b. Ignoring
flotation costs, what is the NPV of the proposed project?

c. What is
the weighted average flotation cost, fA, for the firm?

d. What is
the dollar flotation cost of the proposed financing?

e. After
considering flotation costs, what is the NPV of the proposed project?

11.Photosynthesis,
Inc. is considering a project that will result in initial after-tax cash savings
of $2 million at the end of the first year, and these savings will grow at a
rate of 6% per year indefinitely. The firm has a target debt-equity ratio of
1.5, a cost of equity of 20%, and an after-tax cost of debt of 7%. The
cost-saving proposal is somewhat riskier than the usual projects the firm
undertakes; management uses the subjective approach and applies an adjustment
factor of +10% to the cost of capital for such risky projects.

Under
what circumstances should Photosynthesis take on the project? (10
marks)

12.ABC Co.
has the following dividend payment history: (10 marks)

Year

Dividend

2003

$1.00

2004

1.15

2005

1.25

2006

1.35

2007

1.45

a. How many periods of growth are
there in the information given?

b. What is the compound growth rate
of dividends?

c. Calculate the year-to-year
growth rates in dividends.

d. What is the average year-to-year
dividend growth rate?

e. Assume a retention ratio of 0.45
and a historical return on equity (ROE) of 0.18. Using these two additional
pieces of information, calculate an alternative estimate of dividend growth
rate, g.

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