Final exam solution sketches

Winter 2014, Version A

Note for multiple-choice questions:

Choose the closest answer
Profitability Index
 If the effective annual discount rate is
10%, then what is the profitability index
if someone invests $900 today in a
project that pays out $1250 three years
from today?
 PVcash flows = 1250/(1.1)3 = 939.14
 P.I. = 939.14/900 = 1.0435
Confidence Interval
 95.44% of the probability distribution is
within 2 standard deviations of the
mean of a normal distribution. Assume
the historical equity risk premium is
12.5%, and the standard deviation of
the equity risk premium is 18.0%. 256
years of data were used to make these
estimates.
Confidence Interval
 Find the LOWER BOUND of the 95.44%
confidence interval of the historical
equity risk premium.
 Lower bound of 95% C.I.:
 = 12.5% - 2 * 18%/(256)1/2
 = 12.5% - 2 * 18%/16
 = 12.5% - 2 * 1.125%
 = 10.25%
Perpetuity
 An asset promises to pay $6 per year
forever, starting six months from today.
The stated annual discount rate for this
asset is 18%, compounded twice per
year. What is the present value of this
stream of payments?
 EAR = (1.09)2 – 1 = 18.81%
 PV = 6/.1881 * 1.09 = $34.77
1st payment is in 6 months, not 1 year
CAPM
 If the market return is 20%, the risk-
free rate is 10%, and the beta of Stock
X is 5, what is the expected annual rate
of return for Stock X?
 Risk premium = 20% - 10%
 Expected return = 10% + 5*(20% - 10%)
 Expected return = 60%
Random Walk
 Use the following information to answer the
next three questions:
 Suppose that the daily price of each share of
Wibby Pig stock is a random walk with each
day’s movement in price independent of the
previous day’s price change. Every day, the
stock can either go up or down by $3, each
with 50% probability. The stock is currently
valued at $60.
Random Walk Probability
 What is the probability that the value of
the stock two days from now will be
$60?
 The stock price two days from now will be
$60 if the price path is either (up, down) or
(down, up)
 Pr(up, down) = Pr(down, up) = 25%
 Pr(price = $60) = 2 * 25% = 50%
Call Option and Random Walk
 What is the present value of a European
call option with an expiration date two
days from now if the exercise price of
the option is $62? Assume a daily
discount rate of 0.05%, with daily
discounting.
 Pr(value ≤ $62) = 3/4
 Pr(value > $62) = 1/4 (Only up, up)
 PV = 1/4 * (66 - 62)/(1.0005)2 = $0.99900
Put Option and Random Walk
 A put option has an exercise price of
$53, and this option expires three days
from today. What is the probability that
this option will have positive value on
the expiration date?
 Only down, down, down will lead to a
price < $53
 Pr(down, down, down) = (1/2)3 = 1/8
 Pr(down, down, down) = 12.5%
Cost of Equity and WACC
 Trackety’s Trains currently has $300,000 of
stock issued, with no bonds. The current cost
of equity is 10%. If the company sells
$100,000 of bonds and uses this money to
buy back $100,000 worth of stock, what is
the new cost of equity? Assume that the cost
of debt is 1% and that there are no other
securities issued by Trackety’s Trains. You
can also assume that the weighted average
cost of capital is constant.
Cost of Equity and WACC
 RS = R0 + B/S * (R0 – RB)
 RS = 10% + 1/2 * (10% – 1%)
 RS = 10% + 1/2 * (9%)
 RS = 14.5%
Cost of Equity and WACC
 Alternative Method:
 Before bond sale/stock purchase:
 RWACC = 0 * RB + 300,000/300,000 * RS
 RWACC = 10%
 After bond sale/stock purchase:
 S = 300,000 – 100,000 = 200,000
 B = 100,000
 10% = 1/3 * 1% + 2/3 * RS
 RS = 14.5%
Dividends
 Harptonia is a company that sells drinks with
harps on the front label. Harptonia’s
dividends are paid as follows: Dividends are
paid every 4 months, with the next dividend
to be paid 4 months from now. The next 3
dividend payments will be $1 per share. Each
subsequent dividend payment will be 15%
higher than the dividend payment made one
year before.
Dividends
 If we assume that this company will pay
dividends forever, what is the present value of
this stock if the stated annual discount rate is
20%, compounded every 4 months?
 4-month rate = 20%/3 = 6.66667%
 EAR = (1.06667)3 – 1 = 21.36296%
 Year 1: PV = 1/1.06667 + 1/(1.06667)2 +
Annual equivalent
1/(1.06667)3 = $2.6404 of 3 payments
 PV = 2.6404 + 2.6404*1.15/(.21363-.15)
 PV = $50.36
Dividends
 Alternate Method: 3 annuities with annual
payments that grow by 8%, but whose start
dates are 4 months, 8 months, and 12 months
 Annuity with 1st payment in 4 months:
 PV = 1/(.21363-.15) * (1.06667)2
 Annuity with 1st payment in 8 months:
 PV = 1/(.21363-.15) * (1.06667)
 Annuity with 1st payment in 12 months:
 PV = 1/(.21363-.15)
 Total PV = $50.36
Portfolio Standard Deviation
 Stock 1 has an 8% annual rate of return if
state A occurs, 11% if state B occurs, and
20% if state C occurs. Stock 2 has a 15%
annual rate of return if state A occurs, 8% if
state B occurs, and 7% if state C occurs.
Assume all 3 states occur with equal
probability. What is the standard deviation of
a portfolio that has 50% of money invested in
stock 1 and 50% invested in stock 2?
Portfolio Standard Deviation
 Expected returnStock1 = (.08+.11+.2)/3 = .13
 Expected returnStock2 = (.15+.08+.07)/3 = .1
 VarStock1 = 1/3 * [(.08-.13)2 + (.11-.13)2 +
(.2-.13)2] = 1/3 * [.0078] = .0026
 VarStock2 = 1/3 * [(.15-.1)2 + (.08-.1)2 +
(.07-.1)2] = 1/3 * [.0038] = .0012667
 Cov1,2 = 1/3 * [(.08-.13)(.15-.1) + (.11-
.13)(.08-.1) + (.2-.13)(.07-.1)]
 Cov1,2 = 1/3 * [-.0042] = -.0014
Portfolio Standard Deviation
 Variance of a portfolio:
 Var = (1/2)2(.0026) + 2(1/2)(1/2)(-.0014) +
(1/2)2(.00126667) = .00065 – .0007 +
.00031667
 Var = .0002667
 s.d. of portfolio = (.0002667)1/2 = 1.6330%
Call Option
 Itty Bitty Ball Bell stock could have
value of $50, $55, $60, or $65 two
years from today. Each outcome occurs
with equal probability. If a European
call option with an exercise price of $58
and expiration date two years from
today has a present value of $1.80,
what is the effective annual discount
rate of this option?
Call Option
 Exercise call option if price at expiration
is $60 or $65 (prob of each is 1/4)
 $1.80 = 1/4 * (60-58)/(1+r)2 + 1/4 *
(65-58)/(1+r)2
 $1.80 = 1/4 * 1/(1+r)2 * (2 + 7)
 (1+r)2 = 9/4 * 1/1.8 = 1.25
 1+r = 1.11803
 r = 11.803%
College Savings
 Suppose that you are advising a couple with
one child about how much they need to save
for college. The child is currently 8 years old,
and will start college at age 18. The first
payment for college will be $50,000, to be
paid 10 years from today. Subsequent annual
payments of $50,000 each will be made until
the child is 21 years old. The effective annual
interest rate is 12%.
College Savings
 If the couple made a deposit of $X today into
the account, this will be exactly enough to
cover all of the child’s college expenses. Find
X.
 PVCollegeCosts = 50,000/(1.12)10 +
50,000/(1.12)11 + 50,000/(1.12)12 +
50,000/(1.12)13
 PVCollegeCosts = 16,098.66 + 14,373.81 +
12,833.75 + 11,458.71
 PVCollegeCosts = $54,764.93
Growing & Constant Dividends
 A stock will pay a dividend of $1 later
today. Over the next 10 years, the
annual dividend will go up by 8% each
year. After that, the dividend will
remain constant forever. What is the
present value of this stock if the
effective annual discount rate is 10%?
Growing & Constant Dividends
 Div’d, year 0 = $1
 Div’d, year 10 = 1 * (1.08)10 = $2.1589
 Years 0-9: 10 payment growing annuity
(shifted 1 year earlier because 1st
payment in year 0)
 Years 10+: perpetuity with payment of
$2.1589, discounted by 9 years because
1st payment in year 10
Growing & Constant Dividends
 PV = 1/(.10-.08) * [1 – (1.08/1.10)10]
* 1.10 + 1(1.08)10/.10 * 1/(1.10)9
 PV = 50 * (1 - .832359) * 1.10 +
21.5892 * 1/2.35795
 PV = 9.22025 + 9.15595 = 18.3762
 PV = $18.38
Growing & Constant Dividends
 Alternate Method:
 Years 1-10: 10 payment growing
annuity
 Years 11+: perpetuity with payment of
$2.1589, discounted by 10 years
because 1st payment in year 11
Growing & Constant Dividends
 PV = 1 + 1.08/(.10-.08) * [1 –
(1.08/1.10)10] + 1(1.08)10/.10 *
1/(1.10)10
 PV = 1 + 9.0526 + 8.32359 = 18.3762
 PV = $18.38