EXERCISE 5 (RISK AND RETURN)
1. Perry purchased 100 shares of Ferro, Inc. common stock for $25 per share one year ago. During the year, Ferro, Inc. paid cash dividends of $2 per share. The stock is currently selling for $30 per share. If Perry sells all of his shares of Ferro, Inc. today, what rate of return would he realize? Answer: Realized return = = 28%

2. Tim purchased a bounce house one year ago for $6,500. During the year it generated $4,000 in cash flow. If Time sells the bounce house today, he could receive $6,100 for it. What would be his rate of return under these conditions? Answer: Realized return = = 55%

3. Asset A was purchased six months ago for $25,000 and has generated $1,500 cash flow during that period. What is the asset's rate of return if it can be sold for $26,750 today? Answer: Realized return = = 13% (semi annual). For annual 13% x 2 = 26% 4. Assuming the following returns and corresponding probabilities for asset A, compute its standard deviation and coefficient of variation.

Answer:

SD = 3.87%
CV = SD/K = 3.87/15 = 0.26
Champion Breweries must choose between two asset purchases. The annual rate of return and related probabilities given below summarize the firm's analysis. 5. For each asset, compute
(a)the expected rate of return.
(b)the standard deviation of the expected return.
(c)the coefficient of variation of the return.
(d)Which asset should Champion select?
Answer:
(a)

Expected Return = 15% Expected Return = 15%
(b) Asset A
(10% – 15%)^2 × 0.30 = 7.5%
(15% - 15%)^2 × 0.40 = 0%
(20% - 15%)^2 × 0.30 = 7.5%
15%
Standard Deviation of A = 3.87%
Asset B
(5% - 15%)^2 × 0.40 = 40%
(15% - 15%)^2 × 0.20 = 0%
(25% - 15%)^2 × 0.40 = 40%
80%
Standard Deviation of B = 8.94%
(c) CVA = 3.87/15 = 0.26 CVB = 8.94/15 = 0.60
(d) Asset A; for 15% rate of return and lesser risk.

6. The College Copy Shop is in process of purchasing a high-tech copier. In...

...UBFF2013 BUSINESS FINANCEQuestion:
1.
(a)
Frodo Baggins has RM1,500 to invest. His investment counselor suggests an investment that pays no stated interest but will return RM2,000 at the end of 3 years. (i) (ii) What annual rate of return will Frodo earn with this investment? Frodo is considering another investment, of equal risk, that earns an annual return of 8%. Which investment should he make and why?
(b)
Samwise Gamgee was seriously injured in an industrial accident. He sued the responsible parties and was awarded a judgment of RM2,000,000. Today, he and his attorney are attending a settlement conference with the defendants. The defendants have made an initial offer of RM156,000 per year for 25 years. Samwise plans to counteroffer at RM255,000 per year for 25 years. Both the offer and the counteroffer have a present value of RM2,000,000. Assume both payments are at the end of each year. (i) (ii) (iii) What interest rate assumption have the defendants used in their offer (rounded to the nearest whole percent)? What interest rate assumption have Samwise and his lawyer used in their counteroffer (rounded to the nearest whole percent)? Samwise is willing to settle for an annuity that carries an interest rate assumption of 9%. What annual payment would be acceptable to him?
2.
Gandalf Enterprise must consider several investment projects, A through E using the capital asset pricing model (CAPM) and its graphical...

...Valuation and financing enterprises
Professor Robert S. Hansen
Case guide questions
For some helpful ideas, have a look at “How to do case analysis”, it is on the web site.
1) Marriott
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.
Are the four components of Marriott’s financial strategy consistent with it’s growth objective? How does Marriott use its estimate of its cost of capital? Does this make sense? What is the weighted average cost of capital for Marriott Corporation? What risk-free rate and risk premium did you use to calculate the cost of equity? How do you measure Marriott’s cost of debt? Did you use arithmetic or geometric averages to measure rates of return? What type of investments would you value using Marriott’s WACC? If Marriott use a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time? What is the cost of capital for the lodging and restaurant divisions of Marriott? What risk-free rate and risk premium did you use to calculate the cost of equity of reach division? Why did you choose these numbers? How do you measure Marriott’s cost of debt for each division? Why did you choose these numbers? How did you measure the beta of each division? What is the cost of capital for Marriott contract services division? How did you estimate its cost of equity without publicly traded comparable companies?
2) Gulf Oil Corporation
1.
2.
3....

...and depreciation for five years. Hertz is an all-equity firm in the 34-percent tax bracket. The required return on the firm’s unlevered equity is 10 percent, and the new fleet will not add to the risk of the firm.
a. What is the maximum price that Hertz should be willing to pay for the new fleet of cars if it remains an all-equity firm?
b. Suppose Hertz purchases the fleet from GM for $325,000, and Hertz is able to issue $200,000 of five year, 8% debt in order to finance the project. All principal will be repaid in one balloon payment at the end of the fifth year. What is the Adjusted Present Value (APV) of the project?
17.2 Gemini, Inc., an all-equity firm, is considering a $2.1 million investment that will be depreciated according to the straight-line method over its three-year life. The project is expected to generate earnings before taxes and depreciation of $900,000 per year for three years. The investment will not change the risk level of the firm. Gemini can obtain a three-year, 12.5% loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the third year. The bank will charge the firm $21,000 in flotation fees, which will be amortized over the three-year life of the loan. If Gemini financed the project entirely with equity, the firm’s cost of capital would be 18%. The corporate tax rate is 30%. Using the Adjusted Present Value (APV) method, determine whether or not...

...Question 1
( 5 points) In a world with no frictions (taxes, etc.), value is created by how you finance a project.
True.
False.
Question 2
(5) The return of equity is equal to the return on debt of a project/firm
Always true.
Never true.
Sometimes true.
Question 3
(10 points) Moogle, Inc. is in the same business as Google, Inc., but has recently retired all its debt to become an all-equity firm. Its return on equity has dropped from 12.25% to 10.60% as a result of this. Google, Inc. continues to have debt in its capital structure, and its debt-to-equity ratio is 30%. What is the return on assets of Google, Inc.(No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 3
Question 4
(10 points) Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 4
Question 5
(10 points) You are planning on opening a consulting firm. You have projected yearly cash flows of $2 million...

...1. Refer to the following information:
Stock | E(r) | | Correlation Coefficients |
1 | 0.06 | 0.20 | 1 with 2: -0.10 |
2 | 0.08 | 0.10 | 1 with 3: +0.60 |
3 | 0.15 | 0.15 | 2 with 3: +0.05 |
A portfolio is formed as follows: sell short $1,000 of Stock 1; buy $1,500 of Stock 2; buy $1,500 of Stock 3. The investor uses $1,000 of his own equity, with the remaining amount borrowed at a risk-free interest rate of 4% (with continuous compounding).
(a) Assuming that there are no restrictions on the use of short-sale proceeds, what is this investors expected rate of return?
(b) What are some of the issues associated with short-selling, and what impact could these issues have on the expected return calculated in part (a).
ANSWER
(a) w1 = -1; w2 = 1.5; w3 = 1.5; wr = -1
E(r) = -1*0.06 + 1.5*0.08 + 1.5*0.15 + (-1)*0.04 = 24.5%
(b) short selling is restricted; unable to use proceeds from the short sale; fee for short selling reduces return. All of these restrictions could fundamentally change the return to the portfolio.
2. Consider a European call option on a stock. The stock price is $70, the time to maturity is 12 months, the risk free rate of interest is 10% per annum (with continuous compounding), the exercise price is $65, and the volatility is 32%. A dividend of $1 is expected in six months time. Determine the price of the option using the binomial method with 6-month steps.
ANSWER
3. The current price of silver is $9 per...

...Petrochemical division being the smallest. The capital spending in R&M would remain stable and in petrochemicals was expected to grow. The four primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, optimize its capital structure, and repurchase undervalued shares.
Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been involved in estimating the cost of capital of the company. She calculated the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions. The estimates are used for asset appraisals for capital budgeting and financial accounting, performance assessments; merger and acquisition proposals and stock repurchase decisions.
Financial Analysis
Cost of Capital: By definition, cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk1. For companies which use a combination of debt and equity to finance their businesses, their overall cost of capital is derived from a weighted average of all capital sources, also known as the weighted average cost of capital (WACC).
What we use “Cost of Capital” to evaluate? Cost of capital is an important component of business valuation work. Midland uses the cost of capital to evaluate value of the...

...Revisions Questions – ACFI2005
Question One
Banks invest in financial securities that they hold in their securities portfolio. A proportion of these securities may be government securities. Government securities are regarded as essentially risk-free and therefore pay a low rate of return. Why then do banks invest in this type of security?
• primary source of liquidity—government securities easily converted into cash
• invest short-term surplus funds—securities provide a return, cash does not
• augment investment earnings—another source of income
• use as collateral for future borrowings—security to support bank’s own borrowings
• use for repurchase agreements to raise exchange settlement account funds—sell securities back to central bank and receive cleared funds
• improve the quality of the overall balance sheet—lower risk government securities offset higher risk loans to customers
• manage the maturity structure of the overall balance sheet—average maturity structure of government security portfolio will be less than the loan portfolio
• manage the interest rate sensitivity of the overall balance sheet—purchase government securities with interest rate structures that offset interest rate risk within the overall loan portfolio
Question Two
Scratchleys Ltd just paid a dividend of $1.20 per share. This dividend is expected to grow at a constant rate of 2 per cent per annum. An investor has determined that the...

...operating margin, and return on equity, profit margin, return on assets and return on capital (King 2007). Gross margin QUOTE OR QUOTE It enables the determination of profit before deductions such as taxation and paying of employees. Operating margin QUOTE It is used when a firm does not have operating income. Shows earnings before taxation and paying interest. Profit margin QUOTE It establishes the excess of accumulated profits over the net sales. A positive figure shows that the enterprise made income over the buying price of the goods of services. Return on capital QUOTE It enables the determination of the money generated over and above the assets invested. Liquidity ratios They determine the availability of cash and finances to pay off debtors in the short term. A companys most liquid assets are compared and how first then can be compared to cash. The greater the liquid assets, the higher the chances of paying off emerging debtors. Such a company can easily meet its running obligations and operations. Less liquid assets mean that a red flag has to be raised. Investors need to increase liquidity f such a company. It includes current ratio, acid test ratio, cash ratio and operation cash flow (King, 2007). Current ratio QUOTE It aims to establish the excess of current assets over current liabilities. The ratio establishes the short term success of a business entity. Acid-test ratio (Quick ratio) QUOTE Cash ratio QUOTE Operation cash...