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MFIIN11270

04:CorporaateFinancee
Spring2017

Prof.OuzhanKaraaka


ProblemSet#2

LecturreNotes#5
1. Re eviewthefolllowingquestiionsatthePrroblemSetss ectionofBMA,Chapter20
0:
Questions15,
Q 16,and18.

LecturreNotes#6
2. Re eviewthefolllowingquestiionsatthePrroblemSetss ectionofBMA,Chapter6::
Questions6,10
Q 0,and11.

3. A food processing company has just de eveloped a n ew kind of soup. It is now
w trying to d
decide
whethertobu
w ildaplantanndputthesoupintoproduuction.Inund dertakingthisscapitalbudggeting
exxercise whichh of the follo
owing cash flows
f should be treated as incremental when deeciding
whethertogo
w aheadandprroducetheso oup?
A.. Theresearchandde evelopmentccoststhatweereincurredd developingthesoup.
B.. Thevalueofthelan ndtheplantwwillbebuiltonnwhichiscurrentlyownedbythecom mpany.
C.. Theco onsequentred esalesofthe company'sexistingsoupb
ductioninthe brands.
D. Thesalvagevalueo ndequipmen tattheendo
oftheplantan ofitsplanned dlife.
E. Thean nnualdepreciaationcharge.
F. Marketingexpensesfortheprod duct.
G. Aprop portionofexp pensesfortheheadofficeeassumingth heseexpenseesareindepeendent
ofwhe ethersoupisproduced.
H. InteresstPayments.
I. DividendPayments.
J. Theexxpendituresfiveyearsfrom mnowwhich willbenecesssarytoensu uretheplant meets
regulattionswhichw willcomeintooforcethen.

4. Th he Follies Co
ompany need ds to replace some of ttheir lightingg equipment. They can either
puurchaselightssfromGEor fromPhilips..TheGEequ ipmentlasts forfouryearrswhiletheP Philips
eqquipmentlasttsforthree.TThediscountrateforthistypeofprojeectis10%.Theperforman nceof
thhetwotypes oflightisthe esame.The aftertaxcostts(i.e.alltheefiguresbelo owarenegatiive)at
eaachdateareaasfollows:

MFIN112704ProblemSeet2 1 of4 Spring


g2017
t=01234
GE 505101520
Philips 305515

Whichistheequipmentwiththelowestequivalentannualcost?

5. Afirmhasachoiceofundertakingaprojectnowornextyear.Thecashflowsinthetwocases
areasfollows:

t=0123
Startnow 1012180
Startnextyear081317
Whenshouldthefirmundertaketheprojectifthediscountrateis5percent?

6. ITT is building a new plant to make telephones in South Carolina. The initial working capital
needsoftheplanttofinanceinventory,payrollandsoforthare$5M.Eachyeartheseneedsare
expected to increase by 5 percent. After five years the plant will be closed and the working
capitalrecovered.Inundertakingacapitalbudgetingexercisetoseewhetherornottobuildthe
plant,whatarethecashflowsthatshouldbeincludedtotakeaccountoftheworkingcapital?

ExamStyleQuestions
7. You are asked to evaluate the following wooden cabinet manufacturing project for a
corporation.DevelopatableshowingtheannualcashflowsandcalculatetheNPVofthisproject
atan8%discountrate.Allfiguresaregiveninnominalterms.

20X620X720X8

PhysicalProduction(cabinets)3,1503,7503,800
LaborInput(hours)26,00030,00031,000
Wood(physicalunits)550630650

Therequiredinvestmenton12/31/20X5is$800,000.Thefirmfacesa34%incometaxrate,and
uses straightline depreciation. The salvage value of the investment which will be received on
12/31/X8 will be one fifth of the initial investment. The price of cabinets on 12/31/X5 will be
$250eachandwillremainconstantintheforeseeablefuture.Laborcostswillbe$15perhour
on12/31/X5andwillincreaseat5%peryear.Thecostforthewoodwillbe$200perphysical
unit on 12/31/X5 and will increase at 2% per year. Revenue is received and costs are paid at
year's end (i.e., use yearend prices in calculating revenues and costs so, for example, use the
12/31/X6 prices for calculating 20X6 revenues and costs). The firm has profitable ongoing
operationssothatanylossesfortaxpurposesfromtheprojectcanbeoffsetagainstthese.

LectureNotes#7
8. ReviewthefollowingquestionsattheProblemSetssectionofBMA,Chapter10:
Questions1,2,3,4,6,and7.

9. ReviewthefollowingquestionsattheProblemSetssectionofBMA,Chapter25:
Questions1,2,3,and4.

MFIN112704ProblemSet2 2 of4 Spring2017


LectureNotes#8&9
10. ReviewthefollowingquestionsattheProblemSetssectionofBMA,Chapter7:
Questions10(ignoreparenthesisinparte),11,and14.

11. ReviewthefollowingquestionsattheProblemSetssectionofBMA,Chapter8:
Questions14,15,and19.

12. Whichofthefollowingstatementsis/arecorrect(seeSiegelreadingintheCP)?
A. The total real aftertax rate of return on equity was lower between 19261990 than 1871
1925.
B.Therealrateofreturnonshorttermgovernmentbondswaslowerbetween19261990than
18711925.
C. In the period 19261990 the return from holding stocks for ten years was greater than the
returnfromholdingshorttermbondsforthesameperiod89.2percentofthetime.
D. In the period 18711990 the return from holding stocks for ten years was greater than the
returnfromholdinglongtermbondsforthesameperiod83.3percentofthetime.

13. Whichofthefollowingstatementsis/arecorrect?
A.Meanandstandarddeviationhavethesameunits.
B.Meanisameasureofdispersion.
C. If two random variables have a negative covariance it means they tend to move in the
oppositedirection.
D.Iftworandomvariablesdon'tmovetogetherorinoppositedirectionsonaverageatallthey
haveazerocovariance.
E.Correlationcoefficientsmustbeequalto1and+1orlieinbetween.

14. ThestocksAandBhavethefollowingdistributionsofreturns.

ABProbability
State1 340.2
State2 520.3
State3 480.2
State4 650.1
State5 610.2

(i)Whatarethemeans,variancesandstandarddeviationsofstocksAandB?
(ii)WhatarethecovarianceandcorrelationbetweenstocksAandB?
(iii)Consideraportfoliowith=0.50inAand1=0.5inB.Whatarethemean,varianceand
standarddeviationofthisportfolio?

15. Whichofthefollowingis/arecorrect?
A. When two stocks have a correlation of 1 it is always possible to construct a portfolio with
zerostandarddeviation.
B.Theriskofawelldiversifiedportfoliodependsontheuniqueriskofthestockscontainedin
theportfolio.
C.Otherthingsequal,thegreaterthenumberofindependentstocks(i.e.thecovariancesareall
zero)inanequallyweightedportfoliothesmallerthestandarddeviationoftheportfolio.

MFIN112704ProblemSet2 3 of4 Spring2017


D.Thestandarddeviationofaportfolioisalwaysaweightedaverageofthestandarddeviations
oftheindividualsecurities.
E.Betaisameasureofthemarketriskofastock.
F.Thebetaofapoorlydiversifiedportfolioisequaltotheweightedaverageofthebetasofthe
individualstockswheretheweightsaretheproportionsintheportfolio.

16. Use EXCEL to answer this question. Stock X has mean return 0.15 and standard deviation 0.6.
StockYhasmeanreturn0.10andstandarddeviation0.4.Thecorrelationbetweenthemis+0.1.
Plottheportfoliolocusforthesetwostocksinmeanstandarddeviationspacewiththemeanon
the vertical axis and the standard deviation on the horizontal axis. Specifically, trace the risk
return tradeoff given by combining these two stocks in varying amounts. Let represent the
proportionofwealthinvestedinXand1theproportioninY.Allowtovarybetween0.2and
1.2instepsof0.1.WhatinvestmentsinXandYdotheportfolioswith<0and>1correspond
to?Attachacopyofyourplot(fromExcel)oftheefficiencylocusandthedataitisbasedonwith
youranswers.

17. Supposethatthestandarddeviationofreturnsoneachindividualstockis40%perannumand
thatthecovariancebetweeneachpairofstocksis0.25.Whatistheannualstandarddeviationof
anequallyweightedwelldiversifiedportfolio?(Assume1/N=O)

18. The risk free rate is 8 percent and the expected return on the market portfolio is 16 percent.
Whatistheexpectedreturnonawelldiversifiedportfoliowithabetaof0.6?

19. Phillippeborrows$15,000at5%andinveststhistogetherwith$15,000ofhisownmoneyinthe
marketportfolio.Ifthemarketportfoliohasastandarddeviationof15%,whatisthestandard
deviationofthereturntohisinvestment?

20. Whichofthesestrategieswouldofferthesameexpectedreturntoaninvestorasastockwitha
betaof0.5?
A.InvestingahalfofhermoneyinTbillsandinvestingtheremainderinthemarketportfolio
B.Borrowinganamountequaltoonehalfofherownresourcesandinvestingeverythinginthe
marketportfolio
C. Borrowing an amount equal to her own resources and investing everything in the market
portfolio
D.Noneoftheabove

ExamStyleQuestions
21. (a)Supposetherearethreetypesofpeopleinaneconomy,typeA's,B'sandC's.Therearethree
assetsX,YandZ.AssetsXandYareriskybutassetZisriskfree.TypeA'shold45percentoftheir
portfoliosinX,30percentinYand25percentinZ.TypeB'shold30percentoftheirportfoliosin
X, 20 percent in Y and 50 percent in Z. Type C's hold 15 percent in X, 10 percent in Y and 75
percentinZ.AretheseholdingsconsistentwiththeCapitalAssetPricingModelbeingsatisfied?
Explainverybrieflywhyorwhynot.

(b) Suppose that the Capital Asset Pricing Model holds. The market portfolio has an expected
return of 0.14 and a standard deviation of 0.35. The risk free rate is 0.05. How could you
construct a portfolio having an expected return of 0.20? What are the beta and standard
deviationofthisportfolio?

MFIN112704ProblemSet2 4 of4 Spring2017

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