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Financial Management Assignment 1

Team 4. PGDHRM 15-17


1. During 2003, Sothebys Sold Edgar Degas bronze sculpture petite Danseuse de
Quatorze Ans at an auction price of $10,311,500. Unfortunately the previous
owner had purchased it in 1999 for $12,377,500. What is his annual rate of
return on this sculpture?
To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t 1
r = ($10,311,500 / $12,377,500)1/4 1
r = .0446 or 4.46%

2. You have made your first $2,000 contribution at the age of 22 years to your
individual retirement account. Assuming you earn an 8 percent rate of return
and make no additional contributions, what will your account be worth when you
retire in 38 years? What if you wait 10 years before contributing? (Does this
suggest an investment strategy?)
22 years --------------------------- 38 years
16 years
FV( at 38 years) = 2000(1+0.08)16
=2000(1.08) 16
=6851.88
When waited for 10 years before contributing contributed at 32 years
32 years --------------------------- 38 years
6 years
FV( at 38 years) = 2000( 1.08)6
=3173.74
This shows that we should invest as early as possible to obtain maximum benefit.
3. A 5-year annuity of ten $7,000 semiannual payments will begin 8 years from
now, with the first payment coming 8.5 years from now. If the discount rate is 10
percent compounded monthly, what is the value of this annuity five years from

now? What is the value three years from now? What is the current value of the
annuity?
Effective semi annual rate
= (1+ 0.10/12)6 -1
=(1.00833)6 1
=1.0510 1
= 5.10%
PV at 8 years = 7000/0.0510[1-(1.0510)-10]
= 53790.6
Current PV = 53790.6 / (1.0510)16 = 24269.61
PV 5 years from now = 53790.6/(1.051)6 = 39910.76
PV 3 years from now = 53790.6/ (1.051)10 = 32709.90
4. Prepare an amortization schedule for a five-year loan of $36,000. The interest
rate is 9 percent per year, and the loan calls for equal annual payments. How
much interest is paid in the third year? How much total interest is paid over the
life of the loan?
36000 = c/0.09 [1-(1.09)-5 ]
C = (36000*0.09) / 1 -(1.09)-5 = 9255.32
Beginning
Balance
36000
29984.68
23427.98
16281.15
8490.49

Total Payment
per Year
9255.32
9255.32
9255.32
9255.32
9255.32

Interest

Principal

3240
2698.62
2108.51
1465.30
764.14

6015.32
6556.7
7146.81
7790.02
8491.17

Ending
Balance
29984.68
23427.98
16281.15
8490.49
0.00

Total Interest = 10276.57


Interest Paid in 3rd Year = 2108.52
5. One More Time Software has 9.2 percent coupon bonds on the market with nine
years to maturity. The bonds make semiannual payments and currently sell for
106.8 percent of par. What is the current yield on Lifehouses bonds? The YTM?
The effective annual yield?
Current bond price = 1000 * 106.8% = 1068
Semi-Annually Coupon Received = 1000 * 9.2% /2 = 46
Current annual yield on the bond = (46 * 2)/1068 = 0.0861 = 8.61 %
Yield to maturity r
1068=46[(1-{1/(1+0.5r)}^18]/0.5r +1000/[(1+0.5r)^18]
Solving the above equation r=8.12%
Effective Annual Yield = (1+0.046)^2 1 = 9.41 %
6. Great Pumpkin Farms just paid a dividend of $3.50 on its stock. The growth rate
in dividends is expected to be a constant 5 percent per year, indefinitely.
Investors require a 16 percent return on the stock for the first three years, a 14

percent return for the next three years, and then a 11 percent return,
thereafter. What is the current share price?
PV6 @ 6th year = [3.5 * (1.05^7)]/(0.11-0.05) = 82.08
PV3 @ 3rd year = [3.5 * (1.05^4)/(0.14-0.05)]/[1-{(1.05/1.14)^3}] + 82.08/(1.14^3) =
65.67
PV1 @ current year = [3.5 * 1.05/(0.16-0.05)]/[1-{(1.05/1.16)^3}] + 65.67/(1.16^3) =
50.7

7. Teder Corporation stock currently sells for $50 per share. The market requires a
15 percent return on the firms stock. If the company maintains a constant 5
percent growth rate in dividends, what was the most recent dividend per share
paid on the stock?
Share value= Divdend X (1+ growth rate) / (Required rate of return-Growth rate)
50=D(1.05)/.15-.05
5=D(1.05)
D=4.76
8. Thirsty Cactus Corp. just paid a dividend of $1.45 per share. The dividends are
expected to grow at 30 percent for the next eight years and then level off to a 7
percent growth rate indefinitely. If the required return is 13 percent, what is the
price of the stock today?
1) n=8 / I%=30 / PV=1.45
Therefore FV =1.45(1+30/100)^8 (after 8 years) [FV=PV(1+g)^n]
= 11.83
2) After 8 years it is a growing annuity with a rate of 7%
11.83(1+g)
=11.83(1+7/100)
=11.83 x 1.07 = 12.66
3) 12.66/ (.13-.07) = 210.93
4) N=8 / I%=13 / FV= 210.93 therefore PV = 79.35
5) The sum of first 8 PVs:
=1.45*1.3/1.13+1.45*1.3^2/1.13^2+.+1.45*1.3^8/1.13^8
=22.58
6) Thus the current price of the stock
=79.35+22.58
=101.93
9. A stock has had the following year-end prices and dividends:
Year
Price
Dividend
1
$51.87
2
52.89
$0.84
3
64.12
0.91
4
57.18
1.00
5
67.13
1.11
6
75.82
1.24
What are the arithmetic and geometric returns for the stock?

Return for the stock for First Period (R1) = ( 52.89 51.87 + 0.84 ) / 51.87 = 0.036 or 3.6%
Return for the stock for Second Period (R2) = ( 64.12 52.89 + 0.91 ) / 52.89 = 0.2295 or

22.95%
Return for the stock for Third Period (R3) = ( 57.18 64.12 + 1.00 ) / 64.12 = ( 0.093) or (
9.3%)
Return for the stock for Fourth Period (R4) = ( 67.13 57.18 + 1.11 ) / 57.18 = 0.1934 or
19.34%
Return for the stock for Fifth Period (R5) = ( 75.82 67.13 + 1.24 ) / 67.13 = 0.2969 or 29.69%
Given

No. of Periods ( n ) = 5

So,Arithmetic Return =

1/5

( R1 + R2 + R3 + R4 + R5 ) / 5
( 0.036 + 0.2295 + ( 0.093) + 0.1934 + 0.2969) / 5
( 0.6628 ) / 5 = 0.13256 or 13.256%

So, Geometric Return =


[ ( 1 + R1 ) * ( 1 + R2 ) * ( 1 + R3 ) * ( 1 + R4 ) * ( 1 + R5 ) ]1/5 1
[ ( 1 + 0.036 ) * ( 1 + 0.2295 ) * ( 1 0.093 ) * ( 1 + 0.1934 ) * ( 1 + 0.2969
1
1.084227487 1 = 0.084 or 8.4%

10.
Over a 30-year period an asset had an arithmetic return of 12.8 percent and a
geometric return of 10.7 percent. Using Blumes formula, what is your best
estimate of the future annual returns over 5 years? 10 years? 20 years?
Here we apply Blumes formula:
R(T)= T-1/N-1*Geometric Average+ N-T/N-1* Arithmetic Average
R(5)
= 5-1/30-1*.107+30-5/30-1*.128
= 12.51 %
R(10) = 10-1/30-1*.107+30-10/30-1*.128
= 12.14 %
R(20) = 20-1/30-1*.107+30-20/30-1*.128
= 11.42 %
11.
Bond X is a premium bond making annual payments. The bond pays a 9
percent coupon, has an YTM of 7 percent, and has 13 years to maturity. Bond Y
is a discount bond making annual payments. This bond pays a 7 percent coupon,
has an YTM of 9 percent, and also has 13 years to maturity. If interest rates
remain unchanged, what will be the price of these bonds one year from now? In
three years? In eight years? In 12 years? In 13 years? Whats going on here?
Illustrate your answers by graphing bond prices versus time to maturity.

Bond Value= C x [1-1/(1+r)T]/r + F/(1+r)T


= Present value of the coupons + Present value of the face amount
Here,
C= Coupon Amount, r= YTM, T= Time Period, F= Face Value
We have assumed F to be Rs 1000.
For Bond X, C= 9% of 1000= Rs 90. YTM= 7%.
For Bond Y, C= 7% of 1000= Rs 70. YTM= 9%
Maturity Period is 13 years
Hence, for calculating the bond price 1 year from now, T= 12 years
Similarly, for calculating the bond prices 3 years, 8 years, 12 years & 13 years from now,
T
will be equal to 10 years, 5 years, 1 year & 0 years respectively.
So, on applying the formula, we get the following price values:
Bond Prices

Time to Maturity
(Years)
12
10
5
1
0

X
1158.85
1140.47
1082.01
1018.69
1000

Y
856.78
871.65
922.21
981.65
1000

Bond Value vs Time to Maturity


1400
1200
1000
800

Bond Value (Rs)

600
400
200
0
12

10

12. Consider the following information about three stocks:


State of
Probability of
Rate of Return if State Occurs
Stock B
Economy
State
of Stock A
Economy
Boom
0.40
0.24
0.36
Normal
0.40
0.17
0.13
Bust
0.20
0.00
-0.28

Stock C
0.55
0.09
-0.45
(Marks: 5)

a. If your portfolio is invested 40 percent each in A and B and 20 percent in C, what is the portfolio
expected return? The variance? The standard deviation?
Boom: E(Rp) = ( 0.40 * 0.24 ) + ( 0.40 * 0.36 ) + ( 0.20 * 0.55 ) = 0.254 or 25.4%
Normal E(Rp) = ( 0.40 * 0.17 ) + ( 0.40 * 0.13 ) + ( 0.20 * 0.09 ) = 0.138 or 13.8%
Bust: E(Rp) = ( 0.40 * 0.00 ) + ( 0.40 * ( 0.28) ) + ( 0.20 * ( 0.45) ) = ( 0.202) or 20.2%
E(Rp) = ( 0.40 * 0.254 ) + ( 0.40 * 0.138 ) + ( 0.20 * ( 0.202) ) = 0.1164 or 11.64%
12 = [ { 0.40 * ( 0.254 0.1164 )2 } + { 0.40 * ( 0.138 0.1164 )2 } + { 0.20 * ( 0.202 0.1164 )2 } ]
12 = 0.02803584
1 = ( 0.02803584 )1/2 = 0.1674 or 16.74%

b. If the expected T-bill rate is 3.80 percent, what is the expected risk premium on the portfolio?
Risk Premium =

E(RP ) = Rf + RPM
RPM = E(RP ) Rf = 0.1674 0.038 = 0.1294 or 12.94%

c. If the expected inflation rate is 3.50 percent, what are the approximate and exact expected real
returns on the portfolio? What are the approximate and exact expected real risk premiums on the
portfolio?
Expected real return = E(Rp) Inflation = 0.1674 0.035 = 0.1324 or 13.24%
Expected real risk premium = RPM Inflation = 0.1294 0.035 = 0.0944 or 9.44%

13.
Famas Llamas has a weighted average cost of capital of 10.2 percent.
The companys cost of equity is 14 percent, and its pretax cost of debt is 8.4
percent. The tax rate is 35 percent. What is the companys target debtequity
ratio?

WACC = [S/(S+B)]*RS + [B/(S+B)]*Rb*(1-TC)


0.102 = 0.14/(1+B/S) + [1/(1+S/B)]*0.084*(1-0.35)
0.102 = 0.14/(1+20) + 0.0546/(1+1/20)
0.102(B/S) = 0.14 + .0546 (B/S)
0.0474 (B/S) = 0.038
B/S = 0.8016
B/S = 0.8016
Debt/Equity = 0.8016
14.

Consider the following information about Stocks I and II:

State of
Economy

Probability
of
State
of
Economy
.25
.50
.25

Rate of Return if State


Occurs
Stock I
Stock II

Recession
0.09
-0.30
Normal
0.42
0.12
Irrational
0.26
0.44
exuberance
The market risk premium is 8 percent, and the risk-free rate is 4 percent.
Which stock has the most systematic risk? Which one has the most
unsystematic risk? Which stock is riskier? Explain.
The amount of systematic risk is measured by the of an asset.
Since we know the market risk premium and the risk-free rate, if we know the expected return of the asset we can use
the CAPM to solve for the of the asset. The expected return of Stock I is:

E(R1) = ( 0.25 * 0.09 ) + ( 0.50 * 0.42 ) + ( 0.25 * 0.26 ) = 0.2975 or 29.75%


Using the CAPM to find the of Stock I, we find:
0.2975 = 0.04 + ( 0.08 * 1 )
1 = ( 0.2575 / 0.08 ) = 3.22
The total risk of the asset is measured by its standard deviation, so we need to calculate the standard deviation of
Stock I. Beginning with the calculation of the Stock I variance, we find:
12 = [ { 0.25 * ( 0.09 0.2975 )2 } + { 0.50 * ( 0.42 0.2975 )2 } + { 0.25 * ( 0.26
12 = 0.01861875

0.2975 )2 } ]

1 = ( 0.01861875 )1/2 = 0.13645 or 13.645%

Using the same procedure for Stock II, we find the expected return to be:
E(R2) = ( 0.25 * (0.30) ) + ( 0.50 * 0.12 ) + ( 0.25 * 0.44 ) = 0.095 or 9.5%
Using the CAPM to find the of Stock II, we find:
0.095 = 0.04 + ( 0.08 * 2 )
2 = ( 0.055 / 0.08 ) = 0.6875
And the standard deviation of Stock II is:
22 = [ { 0.25 * ( 0.30
22 = 0.069075

0.095 )2 } + { 0.50 * ( 0.12 0.095 )2 } + { 0.25 * ( 0.44 0. 0.095 )2 } ]

2 = ( 0.069075 )1/2 = 0.2628 or 26.28%

Although Stock II has more total risk than I, it has much less systematic risk, since its beta is much smaller than
I. Thus, I has more systematic risk, and II has more unsystematic and more total risk. Since unsystematic risk can
be diversified away, I is actually the riskier stock despite the lack of volatility in its returns. Stock I will have a
higher risk premium and a greater expected return.
15.

Suppose you observe the following situation:


Security

Expected
Return
Pete Corp.
1.4
.150
Repete Co. .9
.115
Assume these securities are correctly priced. Based on the CAPM, what is the
expected return on the market? What is the risk-free rate?
As per CAPM equation
R=Rf+ (Rm-Rf)
R=Expected return on security
Rf= Risk free rate
= Beta of the security
Rm=Market Rate

Beta

Pete Corp.
.150 = Rf + 1.4(Rm-Rf)
.150 = -0.4Rf +1.4Rm (1)
.115 =Rf+.9(Rm-Rf). (2)
.115=.1Rf+.9Rm
.46=0.4Rf +3.6Rm-----(3)
Solving equations (1) and (3)
.61=5Rm
Rm=.122 Therefore Rm=12.2%
Substituting in equation (1)
Rf=0.052 Therefore Rf=5.2%

16.
Given the following information for Bellevue Power Co. find the WACC.
Assume the companys tax rate is 35 percent.
Debt:
5,000 7 percent coupon bonds outstanding, $1,000 par value, 20
years to maturity, selling for 92 percent of par; the bonds make
semiannual payments.
Common stock: 100,000 shares outstanding, selling for $57 per share; the
beta is 1.15.
Preferred stock: 13,000 shares of 7 percent preferred stock outstanding,
currently selling for $104 per share. Market: 8 percent market risk premium
and 6 percent risk-free rate.
Market values for debt, common stock and preferred shares:
MVD = 5,500($1,000)(0.92) = $4,600,000
MVE = 100,000($57) = $5,700,000
MVP = 13,000($104) = $1,352,000
And the total market value of the firm is:
V = $4,600,000 + 57,000,000 + 1,352,000 = $11,652,000
Now, we can find the cost of equity using the CAPM. The cost of equity is:
RE =00Cost of common equity= Rf + (Rm Rf) Beta= .06 + (.08) * 1.15
= 0.152 or 15.2%
The cost of debt is the YTM of the bonds, so:
After tax cost of Debt= first calculate the YTM of debt, then tax-adjustYTM of bond:
920 +/- PV, 1000 FV, 35 PMT, 40 N, solve for i/y = 3.8981,then multiply 2 to
annualize SA YTM = 7.7962%
After Tax cost of debt = 7.7962 * (1 .35) = 5.0675%And the aftertax cost of debt is:
The cost of preferred stock is:

RP = Cost of Preferred Stock =Dividend / Price=$7.00 / $104.00 =6.73%


Now we have all of the components to calculate the WACC. The WACC is:
WACC = 0.152(5,700,000/11,652,000) + 0.050675 (4,600,000/11,652,000) + 0.
077962 (1,352,000/11,652,000) = .1022 i..e. 10.22%

17. Teardrop Inc., wishes to expand its facilities. The company currently has
10 million shares outstanding and no debt. The stock sells for $50 per share,
but the book value per share is $20. Net income for Teardrop is currently $18
million. The new facility will cost $40 million, and it will increase net income
by $500,000.
a. Assuming a constant price-earnings ratio, what will the effect be of issuing
new equity to finance the investment? To answer, calculate the new book
value per share, the new total earnings, the new EPS, the new stock price,
and the new market to book ratio. What is going on here?
The number of shares outstanding after the stock offer will be the current shares
outstanding plus the amount raised divided by the current stock price, assuming the
stock price doesnt change. So:
Number of shares after the offering = 10 million + $35 million/$50/share [Assuming
there is no flotation costs]
Number of shares after the offering = 10.7 million
Since the par value per share is $1, the old book value of the shares is the current
number of shares outstanding.
New book value per share = [10 million x $40 + .7 million x $50]/10.7 million = $40.65
The current EPS for the company is: $15 million / 10 million shares = $1.50
The current P/E is: $50/$1.50 = $33.33
If the net income increases by $500,000, the new EPS will be:
$15.5 million / 10.7 millions shares = $1.45 per share
i.e.., the transaction is dilutive
Assuming the P/E remains constant, the new share price will be:
(P/E) x (New EPS) = 33.33 x $1.45 = $48.29
i.e., the share price will decline from $50 to $48.29
The current market to book value is: $50/$40 = 1.25
Using the new share price and book value per share, the new market-to-book ratio will
be:
$48.29/$40.65 = 1.1877
Accounting dilution has occurred because new shares were issued when the market to
book ratio was less than 1; market value dilution has occurred because the firm

financed a negative NPV project. The cost of the project is given at $35 million. The NPV
of the project is the new market value of the firm minus the current market value of the
firm or: NPV = -$35 million + [10.7 million x $48.29 10 million x $50]
= -$18,333,333

b. What would the new net income for Teardrop have to be for the stock price
to remain unchanged? For the price to remain unchanged when the P/E ratio
is constant, EPS must remain constant.
The new net income must be the new number of shares outstanding times the current
EPS which gives:
NI = (10.7 millions shares) x $1.50/share
= $16.05 million