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.âs 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 assetsâ 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 â 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 firmâs 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 firmâs tax rate is 34% and ignore the effects of CCA

depreciation. (10 marks)

a. What is

the firmâs 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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