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61 CHAPTER 6

1. Why is short-term debt an attractive source of financing to financial managers? Financial managers like short-term debt for at least three reasons. (1) It is easily obtained by most companies, especially small businesses which do not have access to the capital markets. Accruals (accounts payable, wages payable, taxes payable, etc.) arise naturally in the course of nearly all businesses. Bank loans are widely available to companies of all sizes and types. (2) It is usually the cheapest form of financing available. Debt is normally cheaper financing than equity due to the lower level of risk borne by lenders vs. investors and the tax subsidy for debt financing. Short-term debt is usually cheaper than longer-term debt since yield curves are typically upward sloping. (3) It provides a high degree of financial flexibility. Short-term debt, especially bank loans, can be taken and repaid as needed. Companies can obtain financing when they need it and repay it when they no longer do. 3. Under what conditions would a seller be willing to sell on consignment? on terms of cash before delivery? Under what conditions would a buyer be comfortable with each of these two extreme terms of sale? Consignment is the delivery of goods to a buyer without requiring payment until the buyer resells them to its customer. It is done when the buyer is very financially weak compared to the seller and is effectively serving as a warehouse and/or retail outlet for the seller. Buyers are generally quite comfortable with consignment since they can delay payment until they receive money from their customers, eliminating the need to finance their inventory. With cash before delivery (CBD), the seller demands payment prior to shipping goods. CBD is used when a buyer has the money to pay but is of unknown or questionable creditworthiness. It protects the seller fully, but it is not well liked by buyers who generally agree to it only when there is no alternative way to purchase the goods. 5. Identify some of the hidden costs of accruals. Among the hidden costs of accrualscosts due to delaying payment that are not always immediately obviousare the following possibilities: (1) the costs of poor performance and reduced loyalty from employees who are not paid as frequently as they prefer, (2) the potential reduction in the interest rate on loans from banks that would prefer to be paid more frequently, and (3) the lack of preferred treatment from suppliers who would reward the firm for making payments more promptly. 7. What is a base rate of interest? What are the rates most commonly used for dollardenominated loans? A base rate is a rate used in loan pricing that allows lenders to tie the interest rates they charge to current economic conditions. For example, a quote of prime plus 1 translates to a rate one percentage point above the current value of the prime rate. The most common reference rates used for dollar denominated loans are the U.S. prime rate and LIBOR, the London inter-bank offering rate. 9. What is the difference between assignment of receivables and factoring? Assignment of receivables is the use of receivables as collateral against a loan. By contrast, factoring is the

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selling of receivables. In both cases, the party providing the up-front money normally uses the cash flow from collecting the receivables to repay the amount it lays out and provide a profit. The difference is that with assignment, the lender has recourse to its customershould some of the receivables not turn into cash, the customer must make up the shortfall out of its other cash flows. With factoring, the factor has no recourse to its customeronce the factor has purchased the receivables it can be repaid only by collecting them. 11. Identify three conditions in which term-loan financing is particularly appropriate. Three conditions in which a term loan is appropriate are: (1) to finance an asset of intermediate-term life, thus hedging the loan with the cash thrown off by the asset, (2) as a substitute for a line of credit in a firm with an operating cycle longer than one year, and (3) as a bridge loan to finance the company during a period when its needs are uncertain or financial market conditions make it difficult or expensive to obtain longer-term financing. 13. Why do many companies find off-balance-sheet financing attractive? How might a company's investorsbondholders and stockholdersreact? Off-balance-sheet is attractive to many companies because it permits them to publish financial statements which present the firm as stronger than it really is. Leaving the debt off the right-hand side of the balance sheet lowers the firm's reported financial leverage. Omitting the proceeds from the financing from the left-hand side of the balance sheet increases reported profitability measures based on assets such as return on assets and basic earning power. Investors who are unaware of the off-balance-sheet financing have no basis for reacting to it. However, to the extent that a company's investors learn of its off-balance-sheet financing activitiesfrom the footnotes to the firm's financial statements, from analysts, or from the financial pressthey will react on one of several ways. First, they will recast the firm's financial statements to include the missing financing in order to better understand the company's financial health. If they believe the company still to be strong, and especially if they think that the company has successfully used the off-balance-sheet financing to lower its funding costs, they will most likely approve of it and accord the company a higher market value. On the other hand, if they discover that the company is not as strong as they believed, they will likely consider themselves the victims of misrepresentation and lower the company's market value. 15. Identify the following bond concepts: a. Indenture the formal agreement between lender and buyer specifying the terms of the loan and the relationship of the parties. b. Trustee a third party who represents the interests of the lender(s) to the borrower. c. Mortgage a legal agreement between borrower and lender, distinct from but accompanying the loan agreement, which specifies the loan collateral. d. Debenture a bond without collateral. e. Serial bond a bond carrying a serial number which permits it to be specifically identified and (possibly) retired prior to its maturity date. f. Sinking fund an account set up by the borrower into which the borrower regularly deposits money to repay the loan.

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17. What is a junk bond? Why were junk bonds so popular in the 1980s? Why are they less popular today? A junk bond is a bond which is rated below investment grade on its date of issue. Junk bonds became popular in the early 1980s primarily through the efforts of Michael Milken at the investment banking firm of Drexel, Burnham, Lambert. Milken argued successfully that the interest rate on these bonds was greater than the rate appropriate for their risk of default which made them a very attractive investment. Investors flocked to junk bonds for their high yields, providing a considerable amount of funds to new and high-risk ventures. The 1980s was a period of economic growththere were few defaults on junk bonds throughout most of the decade which supported Milken's assertions. However, the recession and Milken's highly publicized legal troubles in the late 1980s burst the junk bond bubble. Fewer junk bonds are issued today, and those that are outstanding are evaluated much more realistically. 19. What is a floating-rate note? A floating-rate note (FRN) is an intermediate- or long-term bond with a floating interest rate. FRNs are issued in the Eurocurrency markets (where they originated) and in most other major capital markets worldwide. FRNs provide an alternative to traditional bonds with their fixed interest rates, reallocating the risks of interest rate movements between the parties. 21. Is there any difference in value between cumulative and non-cumulative preferred stock? Why, or why not? While the difference is minimal in financially healthy companies, there is a significant difference in companies in financial distress. A company with outstanding cumulative preferred stock cannot pay dividends on its common stock unless all past dividends on the preferred issue have been fully paid. Financially healthy companies routinely pay all preferred dividends; to the preferred shareholders of these firms, the cumulative feature adds little value to the issue because it is highly unlikely that it will ever be invoked. However, companies in financial distress often are cash poor and elect to suspend preferred dividends in order to conserve their cash. To the preferred shareholders of these firms, the cumulative feature is critical to maintaining any value to the preferred shares at all.

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23. What is the difference between primary and fully diluted earnings per share? Primary earnings per share (EPS) is calculated by dividing a corporation's reported net income by the average number of shares outstanding during the year. It is a measure of a company's pershare performance as it actually happened. Fully diluted earnings per share measures what would have happened to EPS if all options on the company's stock had been exercised at the beginning of the year, increasing the average number of outstanding shares and possibly changing net income. For example, if a company's outstanding convertible bonds had been exchanged for common stock, interest expense would have been reduced and the number of outstanding shares would have increased. Both measures must be reported with a company's income statements under GAAP accounting rules. SOLUTION PROBLEM 61 Net credit = accounts receivable accounts payable (a) Net credit = $1,000,000 600,000 = $400,000 Since net credit is positive, the company is a net supplier of trade credit. (b) Net credit = $1,000,000 800,000 = $200,000 Since net credit is positive, the company is a net supplier of trade credit. (c) Net credit = $1,000,000 1,000,000 = $0 Since net credit = 0, the company is neither a net supplier nor a net user of trade credit. (d) Net credit = $1,000,000 1,200,000 = ($200,000) Since net credit is negative, the company is a net user of trade credit. SOLUTION PROBLEM 63 (a) Now Return on assets (ROA) = Net income = 10 = 10% Assets 100 Debt/Equity (D/E) = Liabilities = 50 = 1.00 Equity 50 (b) Lease $5 million Assets 100 5 = 95 million Liabilities 50 5 = 45 million and ROA = 10 = 10.53% 95 D/E = 45 = 0.90 50 (c) Lease $15 million Assets 100 15 = 85 million Liabilities 50 15 = 35 million and ROA = 10 = 11.76% 85 D/E = 35 = 0.70 50 (d) Lease $25 million

Financial Instruments
Assets Liabilities 100 25 = 75 million 50 25 = 25 million

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ROA = 10 = 13.33% 75 D/E = 25 = 0.50 50 As more assets are leased, the company appears to be: (1) more profitable, as ROA (2) less in debt, as D/E SOLUTION PROBLEM 65 (a) $12, as stated in the title of the issue. (b) 14% $100 par value = $14 (c) (1) Amount by which common dividend exceeds $5:$7 5 = $2 (2) Preferred dividend: $10 + 2 $0.25 = $10 + 0.50 = $10.50 (d) Since the common dividend at $7 exceeds $6, the preferred dividend will increase to $7 to equal the common dividend. SOLUTION PROBLEM 67 (a) Issued shares = the 6 million that have been sold to the public. (b) Authorized but not issued shares = 10 million authorized 6 million issued = 4 million (c) Outstanding shares = the 5 million in the hands of investors today. (d) Treasury shares = 6 million issued 5 million outstanding = 1 million. SOLUTION PROBLEM 69 (a) The shareholder's obligation is the par value of $2.50. Since only $1.00 has been paid, the remaining obligation is $2.50 1.00 = $1.50 (b) This shareholder has already satisfied the obligation of $2.50. Remaining obligation = $0 (c) Book value per share = Total owners' equity = $96 million = $8.00 Shares outstanding 12 million (d) Earnings per share = Net income = $25 million = $2.17 Average shares outstanding 11.5 million

71 CHAPTER 7
1. Identify seven functions of financial markets and institutions. Seven functions of financial markets and institutions are: (1) to process payments for goods and services via checks or electronic transfers, (2) to provide investments where individuals can save money and earn a return on their savings, (3) to supply credit in the form of loans to individuals and organizations, (4) to provide mechanisms investments and safe locations for the storage of wealth, (5) to ensure liquidity by bringing together many market participants interested in purchasing a saver's investments, (6) to reduce risk by providing insurance products and transferring risky investments to those parties most capable of bearing them, and (7) to provide a mechanism through which governments can affect the economy. 3. Distinguish among direct transfer, semidirect transfer, and indirect transfer. Which financial organizations play an important role in each? These three terms describe the ways in which money moves from surplus budget units to deficit budget units. They differ by who, if anyone, helps bring the parties together. Direct transfer is the case where the two parties know each other personally and exchange money and obligations without the aid of financial market professionals. Semidirect transfer is the exchange of money and obligations using a broker to bring the parties together. Indirect transfer goes through a financial intermediary each party deals independently with the intermediary and never discovers the other's identity. Brokers with various specialtiesfor example, investment bankers, realestate brokers, commodities brokers, etc.play the primary role in semidirect transfer. The financial intermediaries active in indirect transfer include banks and thrift institutions, insurance companies, pension and endowment funds, and mutual funds. 5. Distinguish between the primary financial markets and secondary financial markets. The primary financial markets are the places where securities are issued for the first time. For the most part this is a network of investment bankers and their clients. The secondary markets are the places where previously issued securities are bought and sold. These consist of the physical exchangessuch as the New York Stock Exchange, and computerized networkssuch as the NASDAQ. 7. How does underwriting work? Underwriting is the purchase of a new security issue by one or more investment banks, therefore guaranteeing a price to the issuing company. The term comes from the world of insurance, in which underwriting refers to issuing insurance policies. The investment banker takes on the responsibility for reselling the securities to the public and absorbs any losses (and makes any gains) if the securities must be resold at a lower (can be resold at a greater) price. By purchasing the securities from the issuer, the underwriter goes beyond a brokerage relationship and effectively acts as a financial intermediary in the transaction. 9. What are the differences between a public security issue and a private placement? The primary difference is the buyerswhether they come from the general public or are a small group known to the issuing company or to its investment bankers. However, this difference

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triggers a legal difference which is more important. Public security issues must be registered with the SEC and go through a complex disclosure process designed to protect the securities' buyers. Privately placed issues, on the other hand, escape the requirement for public registration. As a result, private placements provide greater speed to market, much more privacy for the issuers, negotiated terms which need not conform to market standards, and low cost permitting companies to raise much smaller amounts. 11. Identify five functions of secondary financial markets. Five functions of the secondary markets are: (1) to permit the trading of previously issued securities by bringing many buyers and sellers together, (2) to provide real-time information about securities prices and trading volume, (3) to create continuity in trading so securities are liquid and marketable, (4) to protect participants from fraudulent activities through regulation by the SEC and the exchanges, and (5) to improve the distribution of investment capital to businesses by providing fair price quotes and other information by which investors can make informed judgments. 13. Why do you think Microsoft chose not to list its securities on a physical exchange? Microsoft''s financial managers were convinced that the NASDAQ system had evolved sufficiently so that their stock would receive the same visibility and attract as many potential purchasers as it would on the New York or American Stock exchanges. Given the nature of the company and its product line, it is also possible that Microsoft was attracted by a computerized trading system that was competing successfully with the older, more established system. 15. Contrast technical analysis and fundamental analysis as methods for finding good stock investments. Technical analysis looks at the short-run, focusing on a stock's price rather than its economic value. While it accepts that rational economic analysis determines prices in the long run, it argues that in the short run prices are primarily set by investor's irrational behaviorfear, greed, misunderstanding, etc. Further, investors follow each other's behavior and trends therefore exist in securities prices. Technical analysts look at patterns of stock price movements to identify these trends and extrapolate them into predictions of future stock price movements. By contrast, fundamental analysis focuses on finding a stock's longterm economic value arguing that short-term price movements are too difficult to predict. A true or intrinsic value is calculated for each stock under study. Investors are advised to purchase any stock priced significantly below its intrinsic value since the stock's price should eventually rise to that level. 17. Why does: a. The weak form of the efficient market hypothesis invalidate technical analysis? Technical analysis directs our attention to past security price and volume movements in order to predict future price changes. However, if security prices already contain all information that can be learned from studying past price movements and trading volume, as the weak form of the efficient market hypothesis argues, there is nothing more to be learned from this data set and we are only wasting our time doing technical analysis.

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b. The semistrong form of the efficient market hypothesis invalidate fundamental analysis? Fundamental analysis directs our attention to public information about a company and its business prospects in order to establish its intrinsic value. However, if security prices already contain all information that can be learned from public information, as the semistrong form of the efficient market hypothesis argues, there is nothing more to be learned from this data set and we are only wasting our time doing fundamental analysis. 19. What is the random walk? What is its relationship to the efficient market hypothesis? A random walk is a mathematical process in which each successive change of some variable is independent of previous changes. As applied to securities prices, it is stronger form of the efficient market hypothesis that attempts to specify the statistical pattern of stock price movements. Changes in securities prices have been tested to see if they conform to this model assuming that each price change is independently drawn from some identifiable probability distribution. Unfortunately, the distribution that seems to describe security price changes best is one that has an infinite standard deviation, inconsistent with risk models like the capital asset pricing model which use standard deviation as an input to their measures of risk. 21. Identify five types of intermediation. Describe a situation in which you might wish to use each one. The five types of intermediation are: (1) amount intermediation, (2) risk intermediation, (3) maturity intermediation, (4) portfolio mix intermediation, and (5) information intermediation. While everyone will answer the second part of this question differently, one example of a situation for each is: (1) amount intermediation borrowing a large amount made up of many small deposits from a bank to purchase an automobile. (2) risk intermediation buying insurance on a house by making certain payments in return for coverage should damage occur. (3) maturity intermediation borrowing for thirty years to purchase a house when the money consists of many aggregated deposits with much smaller maturity. (4) portfolio mix intermediation investing one amount in a mutual fund in return for a claim on a diversified portfolio of assets. (5) information intermediation giving a sum of money to a professional investment advisor who uses its extensive information resources to allocate the money to specific investments.

81 CHAPTER 8
1. What is risk? Risk is the possibility that an outcome will differ from what we expectedin particular, it is the possibility that the outcome will be worse than expected. (If we know that an outcome will take place for certain, we face no risk.) Give an example of a risk faced by each of the following stakeholders: Many answers are possible. a. Customers the possibility that a product will not perform as expected. b. Employees the possibility of losing one's job. c. Suppliers the possibility of losing a contract after investing in developing a product and/or relationship. d. Governments the possibility of a company not creating the jobs promised when it applied for and received special tax treatment for locating in the government's jurisdiction. e. Neighbors the possibility that a company which locates nearby will lower the quality of life by creating pollution, traffic jams, etc. f. Lenders the possibility of default on a loan. g. Investors the possibility of receiving a rate of return less than anticipated. 3. Are you risk averse, risk neutral, or a risk seeker? Is your answer absolute or can you think of circumstances where you might have each of these attitudes? While the answer to this question reflects personal tastes, most people have all three attitudes toward risk depending on how much money or personal danger is at stake. When a small amount is involved, most people are risk seekers and will gamble a bit for the excitement value, knowing that there is not much to lose and the possibilityhowever small of a lot to gain. As the amount at risk grows, most people pass through being risk neutral and become risk averters. Now they will only take prudent risks that promise a much greater probability of a decent return. Of course, there are also some people whose attitude toward risk remains constant, regardless of the amount of money or personal danger involved. Some people simply will not take any risks no matter how small. At the other end of the spectrum are a few people who always seem to be taking risks, even when threatening to life, limb and wealth. 5. What is a portfolio? A portfolio is a group of investments held together. Any time an investor (or a company for that matter) owns more than one investment, the investor owns a portfolio. Why do people diversify their investments? People diversify their investments to reduce risk, since the risk of a portfolio is typically less than the average of the risks of the individual investments that make up the portfolio. This will be true whenever the returns from the individual investments in the portfolio are not perfectly correlated, which is almost all of the time. Why is it better to diversify across countries than only within one country? The returns from investments across countries generally are less correlated with one another than investments in companies all within one country. Accordingly, a multi-country portfolio

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typically has less risk than a one-country portfolio. This is because much of the relationship between investments within a country comes from their being a part of the economy of that country. When the country's economy does well, all investments in that country are affected, and vice-versa; we call this the systematic component of an investment's returns and risk. The economies of different countries often move in different directions, reducing the correlation among investments in a multi-country portfolio. 7. Why is it not too useful to diversify by buying the stocks of five companies in the same industry? A portfolio of stocks drawn from a single industry is normally riskier than a more diversified portfolio. This is because the returns from five (or any number of) stocks in the same industry typically are more correlated than the returns from five stocks drawn from five different industries since environmental events tend to affect all companies in an industry in a similar manner. For example, if the government were to mandate that home appliances meet new, stricter safety standards, all appliance makers would be affected. They would all have to spend money to redesign their products and might have to raise prices to cover the additional costs, leading to a reduction in the demand for new refrigerators, stoves, etc. The returns from a portfolio of five appliance stocks might drop significantly as the stock prices of all five companies adjusted to reflect the event. On the other hand, the new appliance safety standard would not affect companies in other industries, so a portfolio of five stocks containing only one appliance manufacturer would be far less affected. 9. Comment on the accuracy of the following assertion: It is easy to diversify away unsystematic risk, but it is impossible to eliminate systematic risk. The first part of the assertion is true, but the second part is not. Naive diversification, constructing a portfolio without paying attention to the correlations among the component stocks, will eliminate unsystematic risk. The only requirement is that there must be roughly 15 or more securities in the portfolio. Anyone can do this easily. Eliminating systematic risk requires finding stocks whose returns are negatively correlated and constructing a portfolio from these stocks with a beta of zero. This is not impossible, since stocks with negative correlation do exist. However, it is very difficult. Companies change over time, causing the correlation of their returns to change. What might appear to be a zero-beta portfolio today might not be tomorrow. 11. What is the beta of a security? The beta of a security is a measure of the relationship between the security's returns with those from the economy, where the economy is typically measured by a broad-based stock index such as the S&P 500. Beta summarizes the correlation between a security's returns and the returns of all other securities, and is therefore a convenient measure of systematic risk. Connect it to the following concepts: a. Low-risk security a security with a beta less than +1. This is a security whose returns vary over a smaller range than the economy as a whole. b. Average-risk security a security with a beta roughly equal to +1 (the beta of the market taken as a whole). This is a security whose returns vary over a similar range as the economy. c. High-risk security a security with a beta greater than +1. This is a security whose returns vary over a larger range than the economy as a whole.

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d. Aggressive security a synonym for a high-risk security, a security with a beta greater than +1. This is a good security to buy if you expect the economy and stock market to rise, since its returns will tend to increase by a greater amount. e. Defensive security a synonym for a low-risk security, a security with a beta less than +1. This is a good security to buy if you expect the economy and stock market to fall, since its returns will tend to fall by a lesser amount. 13. Identify the: a. Capital market line The capital market line (CML) is a graph of expected rate of return as a function of the total risk of an investment as measured by the standard deviation () of its returns. b. Security market line The security market line (SML) is a graph of expected rate of return as a function of the portfolio risk of an investment as measured by the beta () of its returns. Distinguish between them. When should each be used? Both relationships relate returns to risk, attempting to identify the appropriate level of returns for a given level of risk. The CML relates returns to total riskthe total variability of the investment's rate of return. It is the appropriate return-risk relationship for an investment not held in a well-diversified portfolio, for example a small business owned by an individual without substantial other investments. The SML relates returns to portfolio riskthe incremental risk from adding this investment to a well-diversified portfolio of investments. It is the appropriate return-risk relationship for an investment that will be held in a well-diversified portfolio, for example one stock in a mutual fund that diversifies across dozens of securities. 15. The AT&T company sponsors a well-known Collegiate Investment Challenge, in which students simulate managing a $500,000 stock portfolio and compete to see who can produce the highest-value portfolio by the end of the game. What portfolio of stocks is likely to be the winning one? The winning portfolio is likely to be composed of only one stock (not much of a portfolio!). This is because the returns from a portfolio are the average of the returns of its component stocks. A savvy participant in the contest will understand that while a portfolio can reduce risk, it cannot increase returns. Since the risk of the winning portfolio is not an issue, the best strategy is to invest all the money in the one stock expected to increase in value the most. For an analogy, consider a charity event built around gaming tables where everyone receives a set number of chips upon entering the hall in return for their contribution, and the evening's big winner will take home an expensive prize. The same strategy applies. If you make a series of small bets, diversifying your risk, you are very likely to have some chips left at the end of the evening and almost equally certain not to be the big winner. The much better strategy is to bet heavily just a few times. If you lose you are no worse off, but now you have an opportunity to be the big winner. Interestingly, therefore, while the Challenge is intended to be a simulation of how to manage an investment portfolio, in practice it discourages thinking in portfolio terms and encourages gambling. SOLUTION PROBLEM 81 From the Fisher model:

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r = (1 + risk free rate)(1 + risk premium) 1 Since T-bills are considered (relatively) risk free: r = (1.045)(1 + rr) 1 (a) rr = 2% r = (1.045)(1.02) 1 = 1.0659 1 = (b) rr = 4.5% r = (1.045)(1.045) 1 = 1.0920 1 = (c) rr = 7% r = (1.045)(1.07) 1 = 1.1182 1 = (d) rr = 9.5% r = (1.045)(1.095) 1 = 1.1443 1 = SOLUTION PROBLEM 83 (a)
Probability [A] .3 .2 .1 [B] .3 .2 .1 Probability

Chapter 8

.0659 = 6.59% .0920 = 9.20% .1182 = 11.82% .1443 = 14.43%

-15%

15%

30% 45% Return

-15%

15%

30% 45% Return

(b) Expected Return [A] Probability .15 .25 .35 .20 .05 [B] Probability .15 .25 .35 .20 .05

Return 50% 30 20 5 25 Return 25% 20 15 5 0

Product 7.50% 7.50 7.00 1.00 1.25 19.75% Product 3.75% 5.00 5.25 1.00 0.00 15.00%

= Expected return

= Expected return

(c) Standard Deviations

Risk and its Measurement

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Deviation Deviation2 Product (3) = (2) 19.75 (4) = (3)2 (1) (4) 30.25% 915.06 137.26 10.25 105.06 26.27 .25 .06 .02 24.75 612.56 122.51 44.75 2002.56 100.13 Variance = 386.19 Standard Deviation = 386.19 = 19.65% [B] Probability Return Deviation Deviation2 Product (1) (2) (3) = (2) 15.00 (4) = (3)2 (1) (4) .15 25% 10.00% 100.00 15.00 .25 20 5.00 25.00 6.25 .35 15 0.00 0.00 0.00 .20 5 10.00 100.00 20.00 .05 0 15.00 225.00 11.25 Variance = 52.50 Standard Deviation = = 7.25% 52. 50 (d) The securities of Company A are riskier as they have the larger standard deviation of returns. [A] Probability (1) .15 .25 .35 .20 .05 Return (2) 50% 30 20 5 25 SOLUTION PROBLEM 85 (a) The Capital Market Line is Required rate = rf + (price of total risk) = .04 + 0.5 (b) .04 + 0.5(.05) = .04 + .025 = .065 = 6.5% (c) .04 + 0.5(.10) = .04 + .05 = .09 = 9% (d) .04 + 0.5(.15) = .04 + .075 = .115 = 11.5% SOLUTION PROBLEM 87 (a) The expected return from a portfolio is the weighted average of the expected returns of its component securities: Product Security Expected return Amount % return % K 15% $ 5,000 50% 7.5% L 9 3,000 30 2.7 M 20 2,000 20 4.0 $10,000 100% 14.2% (b) K 15% $ 5,000 71.43% 10.71% M 20 2,000 28.57 5.71 $ 7,000 100% 16.42% (c) K 15% $ 5,000 25% 3.75%

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L M N (d) K L M 9 20 12 15% 9 20 3,000 2,000 10,000 $20,000 $ 3,000 3,000 2,000 $ 8,000 15 10 50 100% 37.5% 37.5 25.0 100% 1.35 2.00 6.00 13.10% 5.625% 3.375 5.000 14.00%

Chapter 8

SOLUTION PROBLEM 89 (a) T: [15 + (10) + 20 + 35 + 5] / 5 = 65/5 = 13% U: same as T = 13% V: [5 + 30 + 0 + (15) + 15] / 5 = 35/5 = 7% (b) 50%T + 50%U 1997: 50%( 15) + 50%( 15) = 15% 1998: 50%(10) + 50%(10) = 10% 1999: 50%( 20) + 50%( 20) = 20% 2000: 50%( 35) + 50%( 35) = 35% 2001: 50%( 5) + 50%( 5) = 5% Since T and U produced the same returns, the combination also produces the same returns. Average return still = 13% (c) 50%T + 50%V 1997: 50%( 15) + 50%( 5) = 10% 1998: 50%(10) + 50%( 30) = 10% 1999: 50%( 20) + 50%( 0) = 10% 2000: 50%( 35) + 50%(15) = 10% 2001: 50%( 5) + 50%( 15) = 10% Average return = 10% (d) T and U are positively correlated as they move together. T and V, and U and V are negatively correlated as they move in opposite directions and can be combined to smooth out returns. (d) The two securities have a zero correlation. Since this is less than +1, some variation in each security cancels out with the other leaving less overall variation. SOLUTION PROBLEM 811 (a) ABC Transport is aggressive with its beta > 1. (b) Central Gas & Power is defensive with its beta < 1. (c) ABC up by 1.3 20% = 26% CGP up by .70 20% = 14% (d) ABC down by 1.3 10% = 13% CGP down by .70 10% = 7% SOLUTION PROBLEM 813 Portfolio betas are weighted averages of the betas of their component securities: (a) 20%(1.3) + 80%(.70) = .82

Risk and its Measurement


(b) (c) (d) 40%(1.3) + 60%(.70) 60%(1.3) + 40%(.70) 80%(1.3) + 20%(.70) = .94 = 1.06 = 1.18

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SOLUTION PROBLEM 815 (a) The Security Market Line has the form: Required rate = rf + (market price of risk) = 7% + 6% (b)
Required Rate of Return 13% 6% r f = 7%

SML

(c) (d)

7% + 6%(0.85) = 7% + 5.1% = 12.10% 7% + 6%(1.20) = 7% + 7.2% = 14.20%

WC1 CHAPTER 9
1. What determines investors' required rate of return from a bond or stock? Investors' required rate of return from a bond or stock (or any security) can be modeled using the Fisher equation of interest rates that was introduced in Chapter 6. In this formulation, any interest rate is a combination of a pure rate of return, an inflation premium, and a risk premium. The pure rate is independent of any particular security, however the inflation and risk premiums do depend on the investment in question. Investors determine an inflation premium based on their forecasts of inflation and the maturity of the investmenthow long the investment will be exposed to the inflation rate they forecast. They determine a risk premium based on their forecast of the variability of the investment's returns and the correlation of those returns to the returns from the economy as a whole. Investors' required rate of return then becomes the combination of the pure rate in the economy plus the specific inflation premium and risk premium appropriate for the security. 3. Distinguish between the value of a security and its price. Under what conditions would value equal price? The value of anything is what it is worth to someone. We model a security's value as the present value of the cash flows the investor expects to receive, where the discount rate used to calculate PV contains the appropriate inflation and risk premiums. Since different investors will forecast different cash flows and risks they will each calculate different values, even though we can model their analytical process in the same time-valueof-money terms. The price of a security is the amount it can be bought or sold for in the financial marketplace. Price is determined at the margin by the actions of those investors who are currently buying and selling the security. For a publicly traded security, this number is quoted constantly and is the same for all investors. For some investors, value will equal price if they happen to forecast cash flows and a required rate of return that produce a present value equal to the market price of the security. Other investors will not do such a detailed analysis but will accept that the market where the security trades is sufficiently efficient that the security's price accurately reflects its value. The remaining investors will calculate value numbers that differ from the security's price and will consider it overvalued or undervalued. 5. Identify the following: a. Traditional bond bond with both a regular interest coupon and a final maturity a value. b. Par bond a bond selling at its maturity value (because the bond's coupon rate equals investors' required rate of return). c. Discount bond bond selling at less than its maturity value (because investors' a required rate of return has risen above the bond's coupon rate). d. Premium bond a bond selling at more than its maturity value (because investors' required rate of return has fallen below the bond's coupon rate). e. Zero-coupon bond a bond with no regular interest coupon but only a final maturity value. 7. If a zero-coupon bond never pays an interest coupon, how do investors earn anything? Bond investors can receive their returns in the form of a regular coupon interest payment, a

WC2

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capital gains, or both. In a zero, the full yield-to-maturity comes from the capital gain. Investors always purchase a zero coupon bond at a discount to its maturity value. They sell the bond for more than they paid for it (subject to swings in market interest rates), or hold it to maturity and collect a maturity value greater than the purchase price of the bond. 9. According to the dividend-growth model, a stock which pays no dividends is worthless! Discuss this statement. From a strict formula point of view, the statement appears correct after all, if D1 equals zero, the model calculates a zero present value. And if the reason a company is not paying dividends is poor performance, its value may indeed be low, although probably not zero. However, many companies elect not to pay dividends when they are doing well, especially young and growing firms. As long as a company can reinvest its retained earnings at a rate of return greater than that required by its investors, the investors should see this as a value-adding action which will permit the company to pay high dividends at some future date. The problem is with the dividend-growth model, which cannot deal with a company which pays no dividends for some period but then begins to pay a high dividend in the future. SOLUTION PROBLEM 91 Using the financial calculator: PMT = 8%($1,000) = 85.00 per year FV = 1000 n = 15 years (a) i = 7 PV = $1,136.62 (b) i = 8.5 PV = $1,000 (c) i = 10 PV = $885.91 (d) i = 11.5 PV = $790.10 In (a), with rb < coupon rate, bond sells at a premium. (b), with rb = coupon rate, bond sells at par. (c), with rb > coupon rate, bond sells at a discount. (d), with rb > coupon rate, bond sells at a discount. SOLUTION PROBLEM 93 Using the financial calculator: FV = 1000 PMT = 8%(1,000) = 85.00 per year n = 15 years (a) i = 14 PV = $662.18 (b) Five years from now there will be 10 years of life left to this bond. Change n to 10 and recalculate: n = 10 PV = $713.11 (c) Leave n equal to 10 and change i to 11: i = 11 PV = $852.77 (d) Fourteen years from now, this bond will have 1 year of life left. Change n to 1. (1) i = 10 PV = $986.36

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(2) (3) i i = 14 = 18 PV = PV = $951.75 $919.49

WC3

SOLUTION PROBLEM 95 Using the financial calculator: (a) 16-year bond: FV = 1000 PMT = 85/8%(1000) = 86.25 per year n = 16 years i = 8.625 Compute PV = $1000 35-year bond: FV = 1000 PMT = 86.25 n = 35 years i = 8.625 Compute PV = $1000 (b) 16-year bond: FV = 1000 PMT = 86.25 PV = $1,392.87 n = 16 i = 5 35-year bond: FV PMT n i = = = = 1000 86.25 35 5 PV = $1,593.56 PV = $764.63

(c) 16-year bond: FV PMT n i = = = = 1000 86.25 16 12

PV = $724.08 (d) In part a, when investors' required return equals the coupon rate of both bonds, the bonds sell at par. As required rates vary, the long-maturity bond varies in price by a greater amount FV PMT n i = = = = 1000 86.25 35 12

35-year bond:

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than the shorter-maturity bond. Thus we see that price volatility increases with the bond's maturity! SOLUTION PROBLEM 97 Using the financial calculator: FV = 1000 [ PMT = 0 zero coupon] n = 10 (a) i = 9 PV = $422.41 (b) i = 11 PV = $352.18 (c) i = 13 PV = $294.59 (d) i = 15 PV = $247.18 With no interest coupon to support their value, "zeros" sell at a deep discount to their face value. SOLUTION PROBLEM 99 Using the financial calculator: FV = 1000 PMT = 125/8%(1,000) = 126.25 per year n = 14 years (a) PV = 875 i = YTM = 14.79% (b) PV = 950 i = YTM = 13.44% (c) PV = 1000 i = YTM = 12.625% (d) PV = 1080 i = YTM = 11.45% SOLUTION PROBLEM 911 Using the financial calculator: FV = 975 your selling price PMT = 126.25 annual coupon n = 5 you hold for 5 years (a) PV = 875 i = holding-period yield (b) PV = 950 i = holding-period yield (c) PV = 1000 i = holding-period yield (d) PV = 1080 i = holding-period yield SOLUTION PROBLEM 913 Use the model for the present value of a perpetuity: Value = PV = Dp Rp Here Dp = $5.00 (a) rp = .06 PV = 5.00 = $83.33 .06 (a) rp = .09 PV = 5.00 = $55.56 .09

= = = =

16.09% 13.69% 12.23% 10.10%

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(c) rp = .12 (d) rp = .15 PV = 5.00 = $41.67 .12 PV = 5.00 = $33.33 .15

WC5

SOLUTION PROBLEM 915 Use the model for the present value of a perpetuity: Value = PV = Dp and rp rp = Dp = Dp PV price Here Dp = $5.00 (a) rp = 5.00 = 16.67% 30.00 (b) rp = 5.00 = 7.69% 65.00 (c) rp = 5.00 = 5.88% 85.00 (d) rp = 5.00 = 5.00% 100.00 SOLUTION PROBLEM 917 Use the dividend-growth model: Value = PV = D1 = $2.12 rc = 14% (a) g = 0%: (b) g = 4%: (c) g = 7%: (d) g = 10%: D1 rc g

Value = 2.12 = $15.14 .14 0 Value = 2.12 = $21.20 .14 .04 Value = 2.12 = $30.29 .14 .07 Value = 2.12 = $53.00 .14 .10

SOLUTION PROBLEM 919 Use the dividend-growth model: PV = D1 , or rearranging: rc g

WC6
r = D1 price + g

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Here: most recent dividend = $1.08 growth rate = 10% so D1 = $1.08(1.10) = $1.188 (a) Price = $45 Dividend yield = D1 = 1.188 = 2.64%

price

45
= 10.00% = 12.64% = 1.188 = 1.98%

Capital gains yield = g Total rate of return (b) Price = $60 Dividend yield = D1 price 60 Capital gains yield = g Total rate of return (c) Price = $75 Dividend yield = D1

= 10.00% = 11.98% = 1.188 = 1.58%

price

75
= 10.00% = 11.58% = 1.188 = 1.32%

Capital gains yield = g Total rate of return (d) Price = $90 Dividend yield = D1 price 90 Capital gains yield = g Total rate of return

= 10.00% = 11.32%

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