FINN 3222 Final Exam Study Guide - Solutions Dr.

Judson Russell
1. The monthly returns for securities A, B, C, and the Market (S&P 500) are shown below.
Month 1 2 3 4 5 A, % 14.03 -12.04 19.32 8.53 -7.49 B, % 25.12 -6.09 14.51 24.09 -12.62 C, % 12.98 7.12 9.12 7.12 -8.94 Market (S&P), % 12.02 -14.86 9.23 23.94 -15.72

You should know how to calculate the arithmetic and geometric returns, variance, standard deviation, correlation coefficient, covariance, and beta for each. 2. Using a two-stage dividend discount model determine the present value of a stock with a current dividend (D0) of $3 per share, expected growth of 20% for the next two years, and growth at 3% thereafter. The risk-free rate is 4%, the stocks beta with the market is 1.1 and the expected return on the market is 10%. 3. Company XYZ has a target capital structure of 40 percent debt and 60 percent equity. Its bonds pay 10 percent coupon (semi-annual payout), mature in 20 years, and sell for $849.54 per $1,000 in face value. The company stock beta is 1.2 versus the market. The risk-free rate of interest is 10 percent and the market risk premium is 5 percent. The company is a mature, constant growth firm that just paid a dividend of $2.00 and has a stock price of $27.00 per share. The growth rate in earnings and dividends is 8 percent while the marginal tax rate is 40 percent. What is the after-tax cost of debt, the cost of equity using the CAPM approach, and the cost of equity using the discounted cash flow approach? 4. What is the modified duration for a three-year, semi-annual pay, $1,000 par value, 6.35% coupon bond that is currently priced to yield 1.98%? 5. You should make sure you practice the bonus problem---three-stage stock model. Very important that you can do that. 6. A company requires capital market financing to build a new factory in Brazil. The firm is considering two bonds---one callable, one non-callable. Both bonds pay a semi-annual coupon and have a par value of $1,000 (continued on next page)

Years to Maturity Years to First Call Coupon Par Call Premium Price

Non-Callable 10 na 7.15% 100 na 100.71

Callable 10 5 7.35% 100 102 100.71

Using the information above, calculate the Yield to Maturity on the non-callable bond. Using the information above, calculate the Yield to First Call for the callable bond. Make sure you review the quizzes, concept checks, your midterm exam, and CFA questions for the new material since the midterm. The exam will be rigorous, but fair. I will send the answers to the six study problems here next Wednesday. Practice these without the answers and see if you can get them correct. That way when you see the answers youll either be very confident or know where you made a mistake. Formulas: Geometric = ((1+Ri)^1/n)-1 2 = [(Ri E(ri))2]/n Beta = covariance / 2market Covariance = ab E(rp) = waRa + wbRb Rc = yrp + (1-y)rf y* (E(rp) rf)/0.01A2p CAPM = rf + (E(rm) rf)
Value =

Arthimetic = (Ri)/n = E(r) = 2 Covariance = [[(Ri E(ri))(Rj E(rj))]]/n Coefficient of variation = /E(r) 2p=wa22a+ wb22b+ 2*cov*wa*wb S = (E(rp) rf)/p U = E(r) - 0.005A2 min var : wa = (2b cov)/(2a + 2b 2cov)

C C C M + + + + 1 2 n (1 + y ) (1 + y ) (1 + y ) (1 + y ) n

P0 = [D1/(ke g)]

WACC = ka = wdkd(1-t)+weke

P0 = [D1/(1+ke)1 + D2/(1+ke)2 + + (Dn+1/(ke-g)) /(1+ke)n]

Solutions:

1. The monthly returns for securities A, B, C, and the Market (S&P 500) are shown below.
Month 1 2 3 4 5 A, % 14.03 -12.04 19.32 8.53 -7.49 B, % 25.12 -6.09 14.51 24.09 -12.62 C, % 12.98 7.12 9.12 7.12 -8.94 Market (S&P), % 12.02 -14.86 9.23 23.94 -15.72

You should know how to calculate the arithmetic and geometric returns, variance, standard deviation, correlation coefficient, covariance, and beta for each.
Month 1 2 3 4 5 Arithmetic Geometric Variance Standard Deviation Correlation A B C MKT Covariance A B C MKT A, % 14.03 -12.04 19.32 8.53 -7.49 4.47 3.74 148.80 12.20 A 1 0.847252 0.605601 0.818648 A 148.8043 160.9814 55.55984 156.5046 B, % 25.12 -6.09 14.51 24.09 -12.62 9.00 7.85 242.61 15.58 B 0.847252 1 0.772921 0.958561 B 160.9814 242.611 90.54336 233.9898 C, % 12.98 7.12 9.12 7.12 -8.94 5.48 5.19 56.56 7.52 C 0.605601 0.772921 1 0.619892 C 55.55984 90.54336 56.56304 73.06416 Market, % 12.02 -14.86 9.23 23.94 -15.72 2.92 1.70 245.61 15.67 Mkt 0.818648 0.958561 0.619892 1 Mkt 156.5046 233.9898 73.06416 245.6089

beta

A 0.637211

B 0.952693

C 0.297482

Mkt 1

2. Using a two-stage dividend discount model determine the present value of a stock with a current dividend (D0) of $3 per share, expected growth of 20% for the next

two years, and growth at 3% thereafter. The risk-free rate is 4%, the stocks beta with the market is 1.1 and the expected return on the market is 10%.
k=10.6% dividends PV d1 PV d2 PV P2 P0 PV 3.254973 3.531616 47.86269 54.64928 1 3.6 2 4.32 p2 = 3 4.4496 58.54737

3. Company XYZ has a target capital structure of 40 percent debt and 60 percent equity. Its bonds pay 10 percent coupon (semi-annual payout), mature in 20 years, and sell for $849.54 per $1,000 in face value. The company stock beta is 1.2 versus the market. The risk-free rate of interest is 10 percent and the market risk premium is 5 percent. The company is a mature, constant growth firm that just paid a dividend of $2.00 and has a stock price of $27.00 per share. The growth rate in earnings and dividends is 8 percent while the marginal tax rate is 40 percent. What is the after-tax cost of debt, the cost of equity using the CAPM approach, and the cost of equity using the discounted cash flow approach?
wd we beta rf MRP CAPM, ke D0 P0 g t 40% 60% 1.2 10% 5% 16 2 27 8% 40% % DCF, ke 16.00% kd = after-tax 12% 7.2 %

4. What is the modified duration for a three-year, semi-annual pay, $1,000 par value, 6.35% coupon bond that is currently priced to yield 1.98%?

t 1 2 3 4 5 6

cf 3.175 3.175 3.175 3.175 3.175 103.175 price Macaulay Macaulay Modified

pvcf 3.143876 3.113056 3.082539 3.052321 3.022399 97.25328 112.6675 5.58687 2.793435 2.766051

t*pvcf 3.143876 6.226113 9.247618 12.20929 15.112 583.5197 629.4586

5. You should make sure you practice the bonus problem---three-stage stock model. Very important that you can do that. Practiceyou will see one of these on final. Replicate the example I gave you in class. 6. A company requires capital market financing to build a new factory in Brazil. The firm is considering two bonds---one callable, one non-callable. Both bonds pay a semi-annual coupon and have a par value of $1,000 (continued on next page)
Years to Maturity Years to First Call Coupon Par Call Premium Price Non-Callable 10 na 7.15% 100 na 100.71 Callable 10 5 7.35% 100 102 100.71

Using the information above, calculate the Yield to Maturity on the non-callable bond. Using the information above, calculate the Yield to First Call for the callable bond.
N i PV PMT FV non-call 20 7.04986 100.71 3.575 100 call 10 7.51397 100.71 3.675 102