AP/ADMS 4540 Financial Management Winter Mid-term Exam

Size: px

Start display at page:

Download "AP/ADMS 4540 Financial Management Winter Mid-term Exam"

Joanna Elliott
5 years ago
Views:

1 1 Name: Student ID: Section: AP/ADMS 4540 Financial Management Winter 2011 Mid-term Exam Instructor: Dr. William Lim Time Limit: 2 hours Instructions: Answer all 6 questions of this exam in the spaces provided on the question sheets. (If necessary, you may write on the back of the sheet). Any resemblance to actual or TV characters is purely coincidental and although the stories may appear "plausibly real", they are fictitious. You have 2 hours to work. The marks for each question are given. Please provide the marker with the greatest opportunity to give you credit by showing all calculations clearly. Answers without clear calculations will be penalized. Only normal writing instruments, a calculator and one 8.5"x11" or letter-size page list of hand-written formulas may be used to write this test. This formula sheet must be submitted with the test; otherwise you will automatically receive a mark of zero (0). Question 1 (8 marks) Calculate the duration and volatility of a 5-year, $1,000 face value, 14 percent coupon bond yielding 15 percent with coupons paid annually. Using its duration and volatility, calculate what happens to the price of the bond when the yield to maturity falls to 14 percent. What are the consequences for a financial institution that does not match the duration of its assets to the duration of its liabilities? Note: Show all working steps, including calculations of PV, RV and WV, clearly for full credit.

2 2 Question 2 (15 marks) With Canadian interest rates still at historical lows, McGraw-Hill-Ryerson (MHR) is considering whether to take advantage of its lower cost of debt and refund its old bonds. Suppose the old issue comprises $30 million, 12 percent coupon rate (paid yearly) 20-year bonds that were sold 5 years ago. A new issue of $30 million, 15- year bonds can be sold with a coupon rate of 9 percent (paid yearly). A call premium of 6 percent will be required to retire the old bonds and floatation costs of $1 million will apply to the new issue. The marginal tax rate applicable is 50% and it is expected that there will be a one month overlap during which any funds can be invested in Treasury bills yielding 8 percent. Should MHR refund? Note: Show all four working steps clearly.

3 3 Question 3 (15 marks) Three BAS students and you are interviewing in a roundtable for employment in a prestigious asset management firm run by George and The Man. The interviewer decides to test potential employees by presenting them with the following question: Consider two mutually exclusive projects with net costs and benefits measured by the following cash flows: Year Project A Project B $1,000 -$1, $ $ $ $1,925 0 Which project should a firm undertake? The three BAS students gave different answers. Larry: It s obvious that a firm should undertake Project A because it offers $545 more in net benefits than does Project B. Curley: I think a firm should undertake Project B because it has a higher internal rate of return: approximately 19 percent as opposed to approximately 15 percent. Moe: Actually, there is really little difference between the projects. Take any discount rate, say 11.6 percent. The NPV of each project is about $112. It doesn t matter which one we choose. You are the fourth and final student to speak. 3a. Draw a diagram of the net present value profiles of both projects. (4 marks) 3b. Provide a valid critique of Larry, Curley and Moe s answers. (8 marks) 3c. Provide a brief description of the correct method by which the projects should be evaluated. (3 marks)

4 4 Question 4 (32 marks) After the interview, you meet (Curious) George and The Man (with the Yellow Hat). They are financial managers who network with other managers and analysts. Hoping to work in the industry, you follow them around to impress them and their friends with your knowledge of finance. 4a. You next meet Professor Wiseman. She provides you with the following table which gives some characteristics of two risky assets - stocks and bonds. Also shown are weights in the market portfolio P, which is assumed to be mean-variance efficient, i.e., it provides the highest expected return for its level of variance. Asset Weigh in Market Portfolio P Expected Return Standard Deviation Correlation With Stocks Correlation With Bonds Stocks 0.50? Bonds 0.50? If the expected return on the market portfolio P, E(r P ) is equal to 0.10 or 10 percent, what are the expected returns on stocks and bonds? Assume the risk-free rate, r f, is equal to 0.05 or 5 percent and show all calculations clearly. (8 marks) 4b. George and The Man visit Caillou, CFA, a Canadian mutual fund manager. Caillou uses arbitrage pricing to find asset values. Suppose there are many stocks in the market and that the characteristics of stocks A and B are as follows: Stock Expected Return Standard Deviation A B Suppose that it is possible to borrow at the risk-free rate and the correlation of stocks A and B is -1. What must be the value of the risk-free rate and why? (8 marks) 4c. Assume that security returns are generated by the single-index model, R i = α i + β i R M + ε i, where R i is the excess return for security i and R M is the market s excess return. The risk-free rate is 2%. Suppose also there are 3 securities A, B and C, characterized by the following data: Security β i E(R i ) σ(ε i ) A % 25% B % 10% C % 20% (i) If σ M = 20%, help Caillou calculate the variance of returns of securities A, B and C. (6 marks) (ii) Now assume there are an infinite number of assets with return characteristics identical to those of A, B and C, respectively. If one forms a well-diversified portfolio of type A securities, what will be the mean and variance of the portfolio s excess returns? What about portfolios composed only of type B and type C stocks? (3 marks) (iii) Is there an arbitrage opportunity in the market? If so, show Caillou the money. (3 marks) 4d. Assume the correlation coefficient between the Sid Science Fund and the S&P/TSX index is What percentage of Sid Science Fund s total risk is specific or unsystematic? (4 marks) (You may continue your answer on the following page.)

5 Question 4 (continued) 5

6 6 Question 5 (15 marks) George and The Man send you to Asia to meet a friend. After saying ni hao to Kai-lan, you learn that she is considering investing in several Asian portfolios. 5a. Suppose portfolio returns in the Asian market can be described by a 2-factor model with intercept (3 factors including intercept). Kai-lan asks you to determine the equation that describes the equilibrium returns for the following portfolios: (9 marks) Portfolio Expected Return (%) β i1 β i A B C b. Assume there is a portfolio D with β D1 = What is the equilibrium return on portfolio D? What is the sensitivity of portfolio D to factor 2 β D2? What is the relationship of portfolio D to factor 2? (4 marks) 5c. Suppose there is another portfolio E with the following characteristics: Actual Return = 26%; β E1 = 2.0 and β E2 = 1.5. Would you recommend investment in portfolio E to Kai=Lan? Why? (2 marks) Note: Show all working steps clearly.

7 7 Question 6 (15 marks) Next, Kai-lan sends you into the jungle to meet Diego, the animal rescuer, and his sister, Alicia, the animal scientist. In order to save baby jaguars (Go Diego Go!), Diego and Alicia need compasses and a new jeep. 6a. A cheap compass costs $2 but is good only for one year. An expensive compass costs $5 but could be used for three years. Find the equivalent annual cost of cheap and expensive compasses when the annual discount rate is 10%. Next, find the annual discount rate such that the costs of cheap and expensive compasses are equal. (Hint: Use interpolation and start with r = 20%.) 6b. Suppose the old jeep was purchased ten years ago for $50,000. This vehicle was in CCA Asset Class 8 with a revised CCA rate of 5% (straight line over 20 years). Now suppose Diego receives an offer from Handy Manny to give this vehicle a free fixin so that it is good as new. The upper- and lower-bounds for benefits and costs for the next ten years are as follows, with the jeep expected (as before) to be obsolete with a salvage value of zero after ten years: Base Case Upper-Bound Lower-Bound Annual Benefits $10,000 $12,500 $7,500 Annual Costs $ 5,000 $10,000 $2,500 With the cost of capital (WACC) at 10% and the corporate tax rate at 40% (Diego had formed a corporation to fund his animal rescue operations which, amongst other ventures, manufactures Easy Ups for toddlers), calculate the NPV of the free fixin for the base-, best- and worst-case scenarios. (P/S Expect to ride in the Rocket with the Little Einsteins on the final exam!)

AP/ADMS 4540 Financial Management Winter 2011 Mid-term Exam Answer Key Instructor: Question 1 Question 2

1 AP/ADMS 4540 Financial Management Winter 2011 Mid-term Exam Answer Key Instructor: Dr. William Lim Question 1 (8 marks) Calculate the duration and volatility of a 5-year, $1,000 face value, 14 percent