Financial Management Quiz Answers 2003, Quizzes of Financial Management

Download Financial Management Quiz Answers 2003 and more Quizzes Financial Management in PDF only on Docsity! Quiz 4 (100 Points) Answers 2003 SHOW YOUR WORK! Finance 316: Financial Management John M.R. Chalmers Summer 2003 Associate Professor of Finance 1) (10pts) How much would you have in your account 30 years from today if you placed $50 in an account every month beginning 1 month from today. You expect to earn a return of 8% compounded monthly for the next 30 years. How much do you expect to have in your account at the end of 30 years? Remember this next time you spend $50 on something you really don’t want! This is a future value of an annuity problem. Step 1 what is the PV of this annuity then covert it to PV. 1) PV = 50 [( 1 / (.08/12) - (1/ (.08/12))(1/(1+.08/12)360)] = 6,814 2) FV = PV (1+r/m)nm = 74,518 2) (10 pts) Suppose your friend has $1 million being paid to her 5 years from today. Your friend wants to borrow some money today. Interest rates are 5% APR compounded semi-annually. What is the most that your friend can borrow today if she plans to make no payments until she receives the $1 million five years from today? This is present value problem--how much can you borrow today given that you will have $1 million in five years to pay it back. PV = 1,000,000 / (1+.05/2)2*5 = 781,198 3) (20 pts) You are considering three stocks for your portfolio. The expected return on the market portfolio is 12% and the risk free rate is 4%. Stock Exp. Return σ Correlation with A Correlation with B Correlatio n with C Beta A .45 .2 .1 1.25 B .35 .2 .5 1.00 C .55 .1 .5 .75 a) (5 pts) What is a reasonable estimate of the expected returns for stocks A, B and C? It is reasonable to use the CAPM to estimate the required rate of return for stocks A, B and C. Ra = 4% + 1.25 (.12 - .04) = .14 Rb = 4% + 1.00 (.12 - .04) = .12 Rc = 4% + .75 (.12 - .04) = .10 b) (5 pts) What is a reasonable estimate of the expected return for a portfolio that includes $100 of A, $100 of B, and $200 of C. You can estimate the beta of this portfolio and plug it into the CAPM. βp = wa βa + wb βb + wc βc = .25 (1.25) + .25 (1.00) + .50 ( .75) = .9375 rp = .04 + .9375 (.12 - .04) = .115 OR you can estimate the expected return from the weighted average of returns from part a rp =.25 (.14) + .25 (.12) + .50 (.10) = .115 c) (5 pts) What is the standard deviation of a portfolio that includes $300 of stock B and $700 of stock C? The weight of b is .3 and the weight of c is .7. The correlation between the two stocks is .5. σp = [(.3)2 (.35)2 + (.7)2 (.55)2 + 2 (.3) (.7) (.35) (.55) (.5)](1/2) = .447 d) (5 pts) Explain why it can be true that one stock can have a higher standard deviation and a lower expected return? The standard deviation includes two kinds of risk – systematic and unsystematic. Investors are rewarded only for the undiversifiable (systematic) risk. If one stock has a very high standard deviation but a great deal of unsystematic risk then it can have a lower expected return than a stock with a standard deviation that is predominantly systematic risk. 4) (10 pts) The beta of Nike’s common stock is 1.20. Its capital structure is 40% debt. Nike’s cost of debt is 10%. What is Nike’s required return on equity? What is its WACC? Explain any differences in the cost of equity, cost of debt and WACC. Recall that you can assume that rf = .04 and rm = .12 for this exam. The WACC, or required return on assets represents the underlying required return for Nike’s business. The required return on debt is lower because the debt is less risky than Nike’s overall business because it has a priority claim on the cash flows. The required return on equity is higher than the required return on debt because it is riskier (it is second in line to get paid). For the same reason, it is higher than the required return on assets because the equity is more risky than the underlying business because of its secondary claim on the cash flows created by that business.