EXAM IN INVESTMENTS AND FINANCE, FE2412, 2010-01-17 3 main questions with sequential questions of total 100 points Aid:

Calculator, N B: The examination is individual; you may not communicate with each other N B: Each page must state your name and your social security number (given by BTH to foreign students). N B: Clearly mark where the answer to each question starts and ends and what question it refers to. N B: Include complete calculations and do not round off until last calculation and report any assumption you make in answering a question. About rounding: Use two decimals in your answers as a general rule. If two decimals only result in zeros, use the number of decimals until you get two non-zero number. When answer in SEK, answer without decimals. E.g. 1.1222=1.22, 1.00002333333=1.000023, 12345.2345 SEK= 12345 SEK QUESTION 1 Assume the following about an investment: The initial cost of the investment is 1 000 000 SEK and the free cash flow at the end of each year is 300 000 SEK for 5 years. rf =4,5%, rD=5%, Cov(RInvestment, RMarket)= 3000, Var(RMarket)=2000, [E(RMarket)-rf)]=6%. The firms has 5 000 000 SEK in debts and 500 000 shares outstanding that are traded for 10 SEK. a) What is the firms cost of capital? (Max 16 points)

= 3000 / 2000 = 1,5

E = 500 000 * 10 = 5 000 000 E ( Re ) = 4,5 + 6 * 1,5 = 13,5 5 5 WACC = * 13,5 + * 5 = 9,25% 5 + 5 5 + 5 b) Calculate if the firm shall go ahead and make the investment, i.e. the NPV of the investment? (Max 4 points)
1 1 / (1 + 0,0925)5 NPV = 1 + 300 * 159 365 kr 0,0925

c) Assume that the corporate tax is 30% and the investment is depreciated to zero value linearly in 5 years. Calculate if the firm shall go ahead and make the investment? (Max 16 points)

WACC Tc =

5 5 13,5 + 5 * (1 0,3) = 8,50% 10 10 1 Yearly Depricatio n : = 200 SEK / year 5 1 1 / (1 + 0,085 )5 + 0,7 300 NPVTc = 1 + 0,085 5 1 1 / (1 + 0,085 ) 0,3 * 200 * 63 973 SEK 0,085

QUESTION 2 Assume the following expectations about two assets returns: State Bad Normal Good Probability Asset A Asset B 30% 40% 30% -3% 6% 11% 15% 10% 5%

a) What is the expected return and risk of the two assets? (Max 16 points)
E [R A ] = 0.3 ( 0.03) + 0.4 0.06 + 0.3 0.11 = 4.8% Var (R A ) = 0.3 ( 0.03 0.048) + 0.4 (0.06 0.048) + 0.3 (0.11 0.048)
2 2 2

= 0.003036 SD(R A ) = 0.003036 = 5.51% E [R A ] = 0.3 0.15 + 0.4 0.1 + 0.3 0.05 = 10% Var (RB ) = 0.3 (0.15 0.1) + 0.4 (0.1 0.1) + 0.3 (0.05 0.1)
2 2 2

= 0.0015 SD(RB ) = 0.0015 = 3.87%

b) Assume a portfolio based on 40% of asset A and 60% of asset B. What is the expected return and risk for the portfolio? (Max 16 points)
E [RP ] = 0.4 0.048 + 0.6 0.1 = 7.92% Cov(R A , R A ) = 0.3 ( 0.03 0.048) (0.15 0.1) + 0.4 (0.06 0.048) (0.1 0.1) + 0.3 (0.11 0.048) (0.05 0.1) = 0.0021 Var (RP ) = 0.4 2 0.003036 + 0.6 2 0.0015 + 2 0.4 0.6 ( 0.0021) = 0.00001776 SD(RP ) = 0.00001776 = 0.0042%

c) What is the strength of the relationship between the assets? (Max 4 points)

Corr (R A , R A ) =

0.0021 = 0.98 0.0551 0.0387

QUESTION 3 Consider a project with a free cash flow in one year of 90 000 SEK in a weak economy or 117 000 SEK in a strong economy, with each outcome being equally likely. The initial investments required is 80 000 SEK and the cost of capital is 15%. The risk-free interest rate is 5%. a) Suppose you borrow only 30 000 SEK to finance the project at risk-free rate, what is the firmss equity cost of capital according to MM proposition II? (Max 8 points) 0.5 90000 + 0.5 117000 = 90000 1.15 D rE = rU + (rU rD ) E 30000 rE = 0.15 + (0.15 0.05) = 20% 90000 30000 E [PVCF ] = b) Suppose that to raise the funds for the investment the firm borrows the 80 000 SEK at the risk free rate. What is the cash flow that the equity holders will receive in one year in a weak economy? (Max 4 points) What is the cash flow that the equity holders will receive in one year in a strong economy? (Max 4 points)
Weak = 90000 80000 1.05 = 6000 Strong = 117000 80000 1.05 = 33000

c) Suppose that to raise the funds for the investment the firm borrows the 80 000 SEK at the risk free rate. What is the value of the firms levered equity? (Max 4 points)
PV (E ) = 0.5 90000 + 0.5 117000 80000 = 10000 1.15

d) Suppose that to raise the funds for the investment the firm borrows the 80 000 SEK at the risk free rate and issues equity to cover the reminder. What is then the cost of capital for the firms levered equity? (Max 8 points)
0.5 90000 + 0.5 117000 80000 = 10000 1.15 0.5 6000 + 0.5 33000 10000 = , 1+ x 0.5 6000 + 0.5 33000 1+ x = 10000 x = 95% PV (E ) =

Or using MM proposition 2
Re = 0.15 + 80000 (0.15 0.05) = 0.95 10000