Assignment 1
You have submitted this Assignment on Fri 27 Jul 2012 11:09:14 PM PDT. You achieved a score of 75.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all monetary answers to the nearest dollar (no decimal/cents) and all interest rates to the nearest on hundredth of a percent (two decimal places). Read the syllabus for examples. The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment add up to 100.
Question 1
(5 points) $50 today is worth MORE than $50 tomorrow.
Your Answer | Score | Explanation | |
True | 5.00 | Correct. You understand Time value of money. | |
Total | 5.00 / 5.00 |
Question Explanation
We have assumed time value of money is positive.
Question 2
(5 points) $100 invested for 10 years at 12% interest is worth more in FV terms than $200 invested for 10 years at 4% interest.
Your Answer | Score | Explanation | |
False | 0.00 | Learn how to calculate FVs of simple one-shot cash flows. Intuitively, compounding should favor the first option. | |
Total | 0.00 / 5.00 |
Question Explanation
All about compounding.
Question 3
(5 points) Megan wants to buy a designer handbag and plans to earn the money babysitting. Suppose the interest rate is 6% and she is willing to wait one year to purchase the bag. How much babysitting money (to the nearest whole dollar) will she need to earn today to buy the bag for $400 one year from now? (Enter just the number without the $ sign or a comma)
Answer for Question 3
Your Answer | Score | Explanation | |
377 | 5.00 | Correct. You know it has to be less than $400. | |
Total | 5.00 / 5.00 |
Question Explanation
Simple PV calculation.
Question 4
(10 points) Jeff has $1,000 that he invests in a safe financial instrument expected to return 3% annually. Marge has $500 and invests in a more risky venture that is expected to return 7% annually. Who has more after 20 years? And how much does he/she have in FV terms?
Your Answer | Score | Explanation | |
Marge; 1935 | 10.00 | Correct. You know how to calculate FVs! | |
Total | 10.00 / 10.00 |
Question Explanation
FV calculations of simple one-shot cash flows. Shows power of compounding.
Question 5
(10 points) Don has just received a cash gift of $50,000 from his rich eccentric uncle. He wants to set it aside to pay for his daughter Cynthia’s college education. Cynthia will begin college in 10 years and Don’s financial advisor says that she can earn 7% interest on an investment in a special college fund. How much will Don have in the fund when Cynthia begins college? (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)
Answer for Question 5
Your Answer | Score | Explanation | |
98358 | 10.00 | Correct. You know how to accurately calculate FV. | |
Total | 10.00 / 10.00 |
Question Explanation
Simple future value calculation. The amount has to be at least $85,000 even if you completely ignore compounding.
Question 6
(10 points) Bridgette’s grandparents opened a savings account for her and placed $500 in the account. The account pays 3.5% interest. Bridgette wants to be a singer and she has her heart set on a new karaoke machine. The machine costs $150. How much less will the account be worth in 8 years if she buys the karaoke machine now versus leaving the account untouched? (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)
Answer for Question 6
Your Answer | Score | Explanation | |
198 | 10.00 | Correct. You know that it has to be more than $150, and actually by at least $42. | |
Total | 10.00 / 10.00 |
Question Explanation
Again a simple FV calculation, but need to read the question carefully to save time and calculate it only once.
Question 7
(10 points) Joe is getting ready to buy a car. He has $20,000 in investments earning 4.9% annually. The car also costs $20,000. If he doesn’t pay cash for the car, Joe can get a loan at 2.9% interest for 5 years. The loan is structured so that Joe pays one balloon payment at the end of 5 years. The balloon payment includes the principal plus all interest accrued over 5 years. If Joe takes the loan will he have enough money available from his investments to make the balloon payment? How much will he be short/have to spare?
Your Answer | Score | Explanation | |
Yes; 2331 | 10.00 | Correct decision and correct calculation. | |
Total | 10.00 / 10.00 |
Question Explanation
How to properly calculate the difference in two future values.
Question 8
(15 points) Juan has $100,000 to invest and he has narrowed down his decision to two investments. Option A returns 60% annually for 4 years, but the maximum investment he can make is $10,000. Option B returns 12% annually for 4 years and would require the entire $100,000. Which option produces the best result for Juan and what is the benefit over the lesser option? Assume that the $90,000 not invested in Option A would be placed in a safe deposit box earning no interest.
Your Answer | Score | Explanation | |
Option A; 1816 | 10.00 | Wrong decision, correct calculation, Be careful. | |
Total | 10.00 / 15.00 |
Question Explanation
Slightly more involved, again multi-step future value problem.
Question 9
(15 points) Jessica is in the market for a new car. She has narrowed her search down to 2 models. Model A costs $20,000 and Model B costs $18,000. With both cars she plans to pay cash and own them for 5 years before trading in for a new car. Her research indicates that the trade in value for Model A after 5 years is 50% of the initial purchase price. The trade in value for Model B is 25%. Jessica has no emotional attachment to either model and wants to make a strictly financial decision. The interest rate is 6%. For simplicity assume that operating and maintenance costs for the models are identical every year. Which model is the better decision and how much «cheaper» is it than the alternative?
Your Answer | Score | Explanation | |
Model A; 2110 | 15.00 | Correct choice, correct calculation. | |
Total | 15.00 / 15.00 |
Question Explanation
This a two-step PV decision taking into account net costs of both cars.
Question 10
(15 points) Christine is a new homebuyer. She wants to make sure that she incorporates the cost of maintenance into her decision. She estimates that routine repairs and maintenance on the home she is considering will be $1,590 in the first year (one year from now). Due to the increasing age of the home, she expects that maintenance costs will increase 6% annually. The interest rate is 5%. If she plans to be in the home for 10 years, what is the present value of all future maintenance? (Note that maintenance costs will change annually, and starts one year from now and she plans to do the last one before selling her house.)
Your Answer | Score | Explanation | |
19771 | 0.00 | Many ways to do this, but think of each year’s maintenance, one at a time. | |
Total | 0.00 / 15.00 |
Question Explanation
This is a multi-step calculation; try it the long way on your spreadsheet.
Assignment 2
You have submitted this Assignment on Thu 9 Aug 2012 4:31:17 AM PDT. You achieved a score of 85.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates with up to two decimals. Read the syllabus for examples. The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100.
Question 1
(5 points) Carlos goes to the bank to take out a personal loan. The stated annual interest rate is 12%, but interest is compounded monthly and he will make monthly payments. The effective annual interest rate (EAR) of the loan is less than 12%.
Your Answer | Score | Explanation | |
False | 5.00 | Correct. You understand compounding. | |
Total | 5.00 / 5.00 |
Question Explanation
Basics of compounding.
Question 2
(5 points) Ranjit began setting aside $6,000 per year in a mutual fund at the age of 25. He has turned 34, and has just made a deposit. The mutual fund has returned 6.5% annually. How much does Rajit have in his account today?
Your Answer | Score | Explanation | |
80967 | 5.00 | Correct. You know how to calculate the FV of an annuity. | |
Total | 5.00 / 5.00 |
Question Explanation
Basic FV calculation. He should have a minimum of $60,000. Why?
Question 3
(5 points) Dominique has just turned 65 and she has deposited her annual payment of $20,000 into her retirement account. She made her first such saving deposit into this fund on her 35th birthday. Dominique has also retired and wants to figure out how much money she has in her retirement account for her retired life. You are Dominique’s friend who knows finance. How much is Dominique’s savings worth today given that the fund has earned an annual return of 5.5%? (Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 3
Your Answer | Score | Explanation | |
1548389 | 5.00 | Correct. You know how to calculate the FV of an annuity. | |
Total | 5.00 / 5.00 |
Question Explanation
FV of an annuity calculation. Draw a time line. The minimum she has is $620,000. Why?
Question 4
(5 points) Gerard has estimated that he is going to need enough in his retirement fund to withdraw $75,000 per year beginning on his 66th birthday and for 19 additional years thereafter. How much will Gerard need in his retirement account at age 65 if his fund is expected to earn an annual return of 9.5%?
Your Answer | Score | Explanation | |
660929 | 5.00 | Correct. You know how to calculate the PV of an annuity. | |
Total | 5.00 / 5.00 |
Question Explanation
Mecahnics of calculating the PV of an annuity. The amount has to be a maximum of $1,500,000. Why?
Question 5
(10 points) Hueling owns a rental property on Main street, but she is considering selling the property to another real estate investor. In preparation for negotiating a price, Hueling wants to know the value of the property.The Net Operating Income (NOI) is the cash flow from real estate and the Cap Rate is the rate, where NOI is rental revenue less all expenses except loan servicing. The property has an NOI of $12,000 per year. The local real estate market has a cap rate of 6%. What is a fair price for the property assuming that the building’s life is 35 years?(Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 5
Your Answer | Score | Explanation | |
173979 | 10.00 | Correct. This is a PV calculation of a annuity. | |
Total | 10.00 / 10.00 |
Question Explanation
A PV of an annuity problem in an interesting real world context. The value cannot be more than $420,000. Why?
Question 6
(10 points) Roxanne is in the market for a new house, and she has found a house she likes that is selling for $250,000. The down payment on the house is 20% (the amount that the bank should require you to pay in cash) and Roxanne plans to finance the remainder with a fixed rate mortgage. The annual rate is 6% and the mortgage is for 15 years, though payments are monthly. What is the interest component of Roxanne’s first monthly payment?
Your Answer | Score | Explanation | |
1000 | 10.00 | Correct. Interest is paid on what you have borrowed for that period. | |
Total | 10.00 / 10.00 |
Question Explanation
This is a simple question, but one which shows your understanding of a loan and what the interest is a function of.
Question 7
(15 points) Abebi, who has just celebrated her 29th birthday, will retire on her 55th birthday, and she has just set up a retirement plan to pay her income starting on her retirement day, and to continue paying for 19 more years. Abebi’s goal is to receive $120,000 for each of these twenty years. In creating her retirement account, Abebi has committed to set aside equal payments at the end of each year, for the next 25 years starting on her 30th birthday. If the annual interest rate is 9%, how big should Abebi’s equal payments be?(Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 7
Your Answer | Score | Explanation | |
12933 | 15.00 | Correct. You know how to understand and analyze real world problems with multiple layers. | |
Total | 15.00 / 15.00 |
Question Explanation
A multi-layer problem, now that you know the mechanics of most calculations.Draw a timeline; it is key. Remember a spreadsheet is a time line.
Question 8
(15 points) Two years ago Abilia purchased a $10,000 car; she paid $2000 down and borrowed the rest. She took a fixed rate 60-month installment loan at a stated rate of 8% per year. Interest rates have fallen during the last two years and she can refinance her car by borrowing the amount she still owes on the car at a new fixed rate of 6% per year for 3 years. Should Abilia refinance her loan? How much will she save per month for the next three years if she decides to refinance?
Your Answer | Score | Explanation | |
(yes, 5) | 15.00 | Correct. Right decision and right calculation. | |
Total | 15.00 / 15.00 |
Question Explanation
This again is a multi-layer question. Understanding the problem first is the key, and using time lines is the main way you will.
Question 9
(15 points) Two years ago, you purchased a $20,000 car, putting $4,000 down and borrowing the rest. Your loan was a 48-month fixed rate loan at a stated rate of 6% per year.You paid a non-refundable application fee of $100 at that time in cash. Interest rates have fallen during the last two years and a new bank now offers to refinance your car by lending you the balance due at a stated rate of 4% per year. You will use the proceeds of this loan to pay off the old loan. Suppose the new loan requires a $200 non-refundable application fee. Given all this information, should you refinance? How much do you gain/lose if you do?
Your Answer | Score | Explanation | |
(no, lose 29) | 0.00 | Correct decision, calculation incorrect. Think about the interest rate you are using at the last stage. | |
Total | 0.00 / 15.00 |
Question Explanation
This is an even more realistic version of the mortgage problem. Think carefully about time lines and relevant interest rates to make different calculations.
Question 10
(15 points) You are interested in a new Ford Taurus. After visiting your Ford dealer, doing your research on the best leases available, you have three options. (i) Purchase the car for cash and receive a $1,500 cash rebate from Dealer A. The price of the car is $15,000. (ii) Lease the car from Dealer B. Under this option, you pay the dealer $500 now and $200 a month for each of the next 36 months (the first $200 payment occurs 1 month from today). After 36 months you may buy the car for $8,000. (iii) Purchase the car from Dealer C who will lend you the entire purchase price of the car for a zero interest 36-month loan with monthly payments. The car price is $15,000. Suppose the market interest rate is 6%. What is the net cost today of the cheapest option? (Enter just the number without the $ sign or a comma; round off decimals.Since this asks for a cost, you just enter the number without a negative sign.)
Answer for Question 10
Your Answer | Score | Explanation | |
13500 | 15.00 | Correct. You understand and can solve real life problems. | |
Total | 15.00 / 15.00 |
Question Explanation
This is a problem that you will face all the time; draw time lines and think through carefully.
Assignment 3
You have submitted this Assignment on Wed 15 Aug 2012 1:24:24 PM PDT. You achieved a score of 90.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100.
Question 1
(5 points) Sachin has asked his flat mate Jason for a $500 loan to cover a portion of his rent and utility costs. Sachin proposes repaying the loan with $300 from each of his next two financial aid disbursements, the first 4 months from now and the second 12 months from now. Jason’s alternative is to earn 5% annually in his money market account. Assume there is no risk of default, and that compounding is monthly. What is the NPV of the loan? (Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 1
Your Answer | Score | Explanation | |
80 | 5.00 | Correct. You know compounding and figuring out NPV. | |
Total | 5.00 / 5.00 |
Question Explanation
This is a simple NPV problem, where the loan is positive NPV only because Sachin cannot borrow at market rates,
Question 2
(5 points) Juanita has an opportunity to invest in her friend’s clothing store. The initial investment is $10,000 and her expected cashflows are as follows: Year 1: $300 Year 2: $500 Year 3: $1200 Year 4: $2000 Year 5: $2000 Year 6: $5000 Year 7: $5000 What is Juanita’s IRR on this investment?(No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 2
Your Answer | Score | Explanation | |
9 | 0.00 | ||
Total | 0.00 / 5.00 |
Question Explanation
This is a simple IRR calculation. Drawing a time line helps.
Question 3
(5 points) Fabrice is looking to buy a new plug-in hybrid vehicle. The purchase price is $12,000 more than a similar conventional model. However, he will receive a $7,500 federal tax credit that he will realize at the end of the year. He estimates that he will save $1,200 per year in gas over the conventional model; these cash outflows can be assumed to occur at the end of the year. The cost of capital (or interest rate) for Fabrice is 6%. How long will Fabrice have to own the vehicle to justify the additional expense over the conventional model?( i.e, What is the DISCOUNTED payback period in years? Discount future cash flows before calculating payback and round to a whole year.)
Answer for Question 3
Your Answer | Score | Explanation | |
0.00 | |||
Total | 0.00 / 5.00 |
Question Explanation
Simple payback calculation, but with discounting.
Question 4
(10 points) Wen Seng operates an ice cream shop. He is trying to decide whether to expand his business to include ice cream cakes. He will need some additional space that will cost him $7,200 per year at the end of each year and some additional equipment that will cost $10,000 up front. The ice cream cakes will provide an extra income of $10,000 per year at the end of each year. The business is expected to last 20 years. The discount rate (or interest rate) for Wen Seng’s new business is 10%. What is the Net Present Value of the ice cream cake project project? (Assume there are no taxes.)
Your Answer | Score | Explanation | |
13838 | 10.00 | Correct. You know how to set up and calculate NPV. | |
Total | 10.00 / 10.00 |
Question Explanation
A fairly common NPV problem
Question 5
(10 points) Yassein is looking to refinance his home because rates have gone down from when he bought his house 10 years ago. He started with a 30-year fixed-rate mortgage of $288,000 at an annual rate of 6.5%. He can now get a 20-year fixed-rate mortgage at an annual rate of 5.5% on the remaining balance of his initial mortgage. (All loans require monthly payments.) In order to re-finance, Yassein will need to pay closing costs of $3,500. These costs are out of pocket and cannot be rolled into the new mortgage. How much will refinancing save Yassein? (i.e. What is the NPV of the refinancing decision?)
Your Answer | Score | Explanation | |
16975 | 10.00 | Correct. This is a very common situation we all face all the time. | |
Total | 10.00 / 10.00 |
Question Explanation
A problem we saw last week, but I expect you to do this routinely now. It is a value generating opportunity through financing only because interest rates changed.
Question 6
(10 points) The United States purchased Alaska in 1867 for $7.2M (where M stands for million). Assume that federal tax revenue from the state of Alaska (net federal expenditures) will be $50M in 2012 and that tax revenue started in 1868 and has steadily increased by 3% annually since then. Assume that the cost of capital (or interest rate) is 7%. What is the NPV of the Alaska purchase? (Hint: Try and imagine you are in 1867 looking forward.)(Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 6
Your Answer | Score | Explanation | |
10515347 | 10.00 | Correct. You can travel in time, both directions. | |
Total | 10.00 / 10.00 |
Question Explanation
Slightly tricky only if you have not drawn a timeline.
Question 7
(10 points)This question introduces you to the concept of an annuity with growth. The formula is given on p.3, equation (7), of the Note on Formulae, but I would encourage you to try doing it in Excel as well. (If the first cash flow is C, the next one will be C(1+g), and so on, where g is the growth rate in cash flow). As an example, the present value of an annuity that starts one year now at $100, and grows at 5%, with the last cash flow in year 10, when the discount rate is 7%, is $860. Confirm this before attempting the problem; and use both the formula and excel. What is the NPV of of a new software project that costs $1,000,000 today, but has a cash flow of $200,000 in year 1 that grows at 3% per year till year 20? Similar investments earn 7.5% per year. (Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 7
Your Answer | Score | Explanation | |
1554745 | 10.00 | Correct. Hope you tried both methods. | |
Total | 10.00 / 10.00 |
Question Explanation
This is a set up and calculation problem, nothing new conceptually.
Question 8
(15 points) Rebecca is 28 and considering going to graduate school so she sits down to calculate whether it is worth the large sum of money. She knows that her first year tuition will be $40,000, due at the beginning of the year (that is, right away). She estimates that the 2nd year of tuition would be $42,000. She also estimates that her living expenses above and beyond tuition will be $8,000 per year (assume this occurs at the end of the year) for the first year and will increase to $9000 the next year. She expects to earn $18,000 for an internship (Assume this inflow occurs one year from now). Were she to forgo graduate school she would be able to make $55,000 at the end of this year and expects that to grow 3% annually. With a graduate degree, she estimates that she will earn $85,000/year after graduation, again with annual 3% increases. Either way, she plans to work until 60 (she begins college right away). The interest/discount rate is 6%. What is the NPV of her graduate education? (Note: All cash flows except tuition payments occur at the end of the year.)
Your Answer | Score | Explanation | |
275996 | 15.00 | Correct. You have analyzed a real world problem. | |
Total | 15.00 / 15.00 |
Question 9
(15 points) Rafael owned an apartment building that burned down. The empty lot is worth $70,000 and Rafael has received $200,000 from the insurance company. Rafael plans to build another apartment building that will cost $275,000. His real estate adviser estimates that the expected value of the finished building on the real estate market will be $385,000 next year. The discount/interest rate is 10%? What are the NPV and IRR of this decision?
Your Answer | Score | Explanation | |
($5,000, 11.59%) | 15.00 | Correct. You know what cash flows matter and how to figure out both NPV and IRR, albeit in a simple context, | |
Total | 15.00 / 15.00 |
Question Explanation
A simple calculation, but the problem has an interesting aspect from real life.
Question 10
(15 points) Roxanne invested $500,000 in a new business 6 years ago. The business was expected to pay $8,000 each month for the next 21 years (in excess of all costs). The annual cost of capital (or interest rate) for this type of business was 9%. What is the value of the business today?(Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 10
Your Answer | Score | Explanation | |
788747 | 15.00 | Correct. Value is always based on the future cash flows. | |
Total | 15.00 / 15.00 |
Question Explanation
Here again the calculations are easy if you understand a key aspect of finance; look to the future to figure out value.
Assignment 4
You have submitted this Assignment on Thu 23 Aug 2012 2:06:55 AM PDT. You achieved a score of 100.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. You are strongly encouraged to use spreadsheets. Refer to Note on Sample Cash Flow Template.
Question 1
(5 points) The project with the highest IRR is always the project with the highest NPV.
Your Answer | Score | Explanation | |
False | 5.00 | Correct. Try now to sort this out in different contexts, | |
Total | 5.00 / 5.00 |
Question Explanation
This is all about the fundamental difference between IRR and NPV.
Question 2
(10 points) Ann Arbor is considering offering public bus service for free. Setting up the service will cost the city $0.6M (where M stands for million). The useful life of the buses is 25 years. Annual maintenance of the buses would cost $50,000 per year and they would need a major overhaul in year 15 that will cost a total of $350,000. This overhaul is in addition to the annual maintenance. Annual operating costs will begin at $90,000 in year 1 and grow at 2% per year thereafter. By using the buses as advertisement space, the city will generate a revenue of $75,000 in year 1 and it will grow at 4% per year thereafter. Reduced parking requirements and other benefits generated by the project will save the city $100,000/year. The salvage value (price city can get in the future after maintenance) of the used buses in year 25 is expected to be $150,000. What is the NPV of the bus proposal? Ann Arbor does not pay taxes and the discount rate is 5%.(Again, all cash flows except initial investments happen at the end of the year.) (You are strongly encouraged to use a spreadsheet.)
Your Answer | Score | Explanation | |
29847 | 10.00 | Correct. You apparently have thought through issues. | |
Total | 10.00 / 10.00 |
Question Explanation
A real world problem with some simplifications in cash flows.
Question 3
(5 points) Alpha Inc. has the following two projects that it is considering, and it wants to choose one. Project A has an investment outlay/expense today of $1,000, and its cash flows over the next three years are $500, $600, $700. Project B has an outlay of $2,000, and cash flows of $1,000, $1,200, and $1,400. Which project should Alpha choose? (You can assume no taxes.)
Your Answer | Score | Explanation | |
Cannot make a choice based on information | 5.00 | Correct. What information is missing? | |
Total | 5.00 / 5.00 |
Question Explanation
This question is probing your comfort level and understanding of decision making; and the most common pitfall we confront all the time.
Question 4
(10 points) GE has the following two projects that it is considering; it can choose only one. Project A has an investment outlay/expense today of $10M, and its cash flows over the next three years are $4M, $4M, $5M. Project B has an outlay of $10M, and cash flows of 0, 0, and $14M. Which project should GE choose if the cost of capital for similar projects is 5%?
Your Answer | Score | Explanation | |
Project B | 10.00 | Correct. You seem to have used the right decision criterion. | |
Total | 10.00 / 10.00 |
Question Explanation
This is another example of our tendency to make biased decisions because we gravitate toward the wrong criterion.
Question 5
(5 points) All else equal, firms that provide more financing to their customers will in turn have higher net working capital.
Your Answer | Score | Explanation | |
True. | 5.00 | Correct. You understand an important cost of doing business. | |
Total | 5.00 / 5.00 |
Question Explanation
This is a fundamental question about working capital, a necessary part of any business.
Question 6
(5 points) Last year your firm had revenue of $36 million, cost of goods sold (COGS) of $32 million, Selling, General, & Administration costs (SG&A) of $3 million, Account Receivables (AR) of $6 million, Account Payables (AP) of $4 million and Inventory of $4 million. What will be the free cash flow next/this year if you boost revenue 8%, while holding COGS growth to 3%, and increasing AP 30%, while everything else remains same as last year? (Assume no taxes and no additional capital expenditures.) (You are encouraged to use a spreadsheet even for this specific type of question.)
Your Answer | Score | Explanation | |
4120000 | 5.00 | Correct. You understand basics of cash flow estimation. | |
Total | 5.00 / 5.00 |
Question Explanation
Cash flow estimation for a specific year.
Question 7
(15 points) Rain in Spain (RiS) is a manufacturer of high quality raincoats. Currently, the retail price of each raincoat is $70 and is produced at a cost of $45. This past year, they sold 50,000 raincoats and they expect this number to grow each year by 6% each year for the next 10 years. The operations team at RiS recently brought to your attention a new technology that could lower the cost of production. This technology requires an upfront fixed investment of $2,000,000 and has the capacity to produce up to 90,000 raincoats per year at a 12% lower cost per unit. There is no increased working capital need due to this new technology, and no value of the machine/technology after 10 years. What is the NPV of investing in the new technology? Ignore taxes and assume a discount rate of 14%. (Hint: Think incrementally; the difference between the world without and with this new technology! Also, ignoring taxes will be a big help if you think right.) (Enter just the number without the $ sign or a comma; round off decimals.)(You are strongly encouraged to use a spreadsheet.)
Answer for Question 7
Your Answer | Score | Explanation | |
-150683 | 15.00 | Correct. You exhibit a clear understanding of how to conduct incremental analysis. | |
Total | 15.00 / 15.00 |
Question Explanation
A probing question that is all about the creation of value; incremental value.
Question 8
(15 points) Fresh off the excitement of the 2012 London Olympic Games, you decide that you want your firm to take advantage of the profits to be made for the 2016 games in Rio de Jeneiro. To do so you plan to open a factory in Brazil. After examining the idea, your CFO projects revenues next year (2013) to be $15 million and costs to be $9 million. Both of these are expected to grow at a rate of 25% per year as the excitement for the games builds. Your firms faces a 35% tax rate, a 14% discount rate and you can depreciate your new investment using the straight line method over the four years leading up to the games, at which point the value of the venture moving forward will be $5 million. (This $5 million is the terminal value that is in year 4 (that is, 2016) dollars and is the PV of all cash flows year 5 and beyond.) The capital expenditure of this project is $12M. What is the NPV of the project? Assume that you have no significant working capital costs.(Enter just the number without the $ sign or a comma; round off decimals.) (You are strongly encouraged to use a spreadsheet.)
Answer for Question 8
Your Answer | Score | Explanation | |
9815100 | 15.00 | Correct. You know how to set up and execute a valuation exercise, albeit a simplified one. | |
Total | 15.00 / 15.00 |
Question Explanation
A valuation exercise that includes most of the elements of a real world situation.
Question 9
(15 points) Starbuck’s is considering opening another store in Chicago. A store is expected to have a long economic life, but the valuation horizon is 7 years. The store in Chicago is expected to create revenues of $3M in the first year and they are likely to grow at 2% per year thereafter. The cost of goods sold are $1.2M in year 1 and they are also expected to grow at 2% per year thereafter. Selling and administration costs are likely to be $0.5M in the first year and then grow at 5%. The tax rate is 35%. Starbucks is so good at managing its stores that working capital increases can be assumed to be negligible. But Starbucks will have to invest $3.5M in purchasing a store (with land). The good news is that this outlay can be depreciated straight line over 7 years. Also, Starbucks has estimated that the terminal value in year 7 dollars will be $10M. This value is the value of all cash flows in year 8 and beyond. What is the NPV of opening this new store if the appropriate discount rate is 7.75%?(Again, all cash flows except initial investments happen at the end of the year. Enter just the number without the $ sign or a comma; round off decimals.)(You are strongly encouraged to use a spreadsheet.)
Answer for Question 9
Your Answer | Score | Explanation | |
7879584 | 15.00 | Correct. You are now building spreadsheet models. | |
Total | 15.00 / 15.00 |
Question Explanation
It is time to do a more complete project analysis. Strongly encourage use of spreadsheets to build cashflows, though remember that you can do it step by step as well.
Question 10
(15 points) Big Blue Granite (BBG) needs to purchase a new saw for creating their top quality countertops. Saw A costs $250,000 with $4,000 of annual maintenance costs for the first year that will increase by 5% each year for the 7-year life of the saw. Saw B costs $150,000 with $10,000 of annual maintenance costs for the first year that will increase by 15% each year for the 4-year life of the saw. Which saw should BBG choose? What is the annualized cost of this choice? Assume a discount rate of 12%, and ignore all taxes.
Your Answer | Score | Explanation | |
(A, 59331) | 15.00 | Correct. You know how to figure out the true annualized cost. | |
Total | 15.00 / 15.00 |
Question Explanation
This is a very common situation and wrong decisions are made frequently.
Assignment 5
You have submitted this Assignment on Wed 5 Sep 2012 1:38:01 PM PDT. You achieved a score of 100.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. To be consistent with the real data and across questions in this assignment, all bond pricing questions assume semi-annual compounding. Also, though not necessary, you may want to use the «rate» function to calculate the yield to maturity (YTM) on bonds. Note also that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. NOTE THAT DRAWING TIME LINES AND MAKING SURE THAT YOU HAVE THE TIMING OF CASH FLOWS RIGHT IS IMPORTANT.
Question 1
(5 points) A pure discount (or zero-coupon) government bond has a face value of $10,000 and a yield of 4.88 percent. If the current price of the bond is $6,800, what is the maturity of the bond? (Recall that the compounding interval for bonds is 6 months.) (Choose the closest round number in years.)
Your Answer | Score | Explanation | |
8 years | 5.00 | Correct. You know how to manipulate the simple PV formula. | |
Total | 5.00 / 5.00 |
Question 2
(5 points) For two otherwise identical coupon bonds, the one with the higher rating will have a higher yield.
Your Answer | Score | Explanation | |
False | 5.00 | Correct. You have an intuitive feel for risk and risk aversion. | |
Total | 5.00 / 5.00 |
Question Explanation
Again, capturing an important intuition of bonds and ..stocks.
Question 3
(5 points) To calculate the coupon payment for coupon bonds, you multiply the yield to maturity times the face value of the bond.
Your Answer | Score | Explanation | |
False. | 5.00 | Correct. You understand bonds. | |
Total | 5.00 / 5.00 |
Question Explanation
Apparently mechanical, but an important practical question about bonds. Knowing such simple things is more important than being able to calculate stuff.
Question 4
(10 points) What is the yield to maturity (YTM) of a zero coupon bond with a face value of $1,000, current price of $950 and maturity of 2 years? (Recall that the compounding interval is 6 months and the YTM, like all interest rates, is reported on an annualized basis.) (Use no more than two decimals in the percentage number, but do not enter the % sign.)
Answer for Question 4
Your Answer | Score | Explanation | |
2.58 | 10.00 | Correct. This is a simple IRR calculation. | |
Total | 10.00 / 10.00 |
Question Explanation
Bond mechanics; calculation of YTM.
Question 5
(10 points) The government in the U.S. issues zero-coupon bonds up to one year maturity, but STRIPS are «manufactured» zero-coupon bonds with maturities up to 30 years. So, for example, a financial institution could first buy 200 30-year coupon bonds issued by the government that each pay $5 of coupon every six months. The institution could then sell the combined coupons totaling $1,000 as a separate zero-coupon bond with maturities ranging from 6 months up to 30 years. This is a financial innovation that occurred decades ago in the face of volatile inflation and an increased demand for long-term zero coupon government bonds. Given this information, analyze the following statement: «The the yield to maturity (YTM) of a long-term STRIP will typically be higher than that of a short-term STRIP.»
Your Answer | Score | Explanation | |
True | 10.00 | Correct. You know the basics of bond pricing. | |
Total | 10.00 / 10.00 |
Question Explanation
Simple bond pricing in a richer context; an early introduction to risk and return.
Question 6
(10 points) Suppose Wolverine Steel Company wishes to issue a $100,000 bond with a maturity of 5 years to raise $79,720. The market requires a yield to maturity (YTM) of 8% for this company’s borrowing/debt. How much coupon will the company have to pay every six months?(Enter just the number without the $ sign or a comma, and no decimals.)
Answer for Question 6
Your Answer | Score | Explanation | |
1500 | 10.00 | Correct. You know the essential characteristics and the mechanics of bond pricing. | |
Total | 10.00 / 10.00 |
Question Explanation
This question is attempting to gauge your complete understanding of the basic characteristics of a bond.
Question 7
(10 points) Suppose you have $10,000 to invest in either (a) Bond A, a 5-year zero-coupon; or (b) Bond B, a 10-year zero coupon bond. Both are risk free government bonds. You plan to hold the bond for a year and your only objective is to take on as little interest rate risk as possible. Which one should you choose?
Your Answer | Score | Explanation | |
Bond A. | 10.00 | Correct. You understand the importance of timing of cash flows. | |
Total | 10.00 / 10.00 |
Question Explanation
This is a probing question about interest rate risk and compounding.
Question 8
(15 points) Three years ago, you invested in a zero coupon bond with a face value of $1,000 that had a YTM of 8% and 9 years left until maturity. Today, that bond has a YTM of 5%. Due to a financial emergency, you are forced to sell the bond. What is your capital gain/loss, which is defined as the dollar gain/loss relative to the price of the bond when you bought it? (Recall that the compounding interval is 6 months and the YTM, like all interest rates, is reported on an annualized basis.) (Enter just the number without the $ sign or a comma, and no decimals.)
Answer for Question 8
Your Answer | Score | Explanation | |
250 | 15.00 | Correct. You know how to figure out a very practical application of bond valuation. | |
Total | 15.00 / 15.00 |
Question Explanation
A practical bond valuation scenario.
Question 9
(15 points) Hard Spun Industries (HSI) has a project that it expects will produce a cash flow of $2.5 million in 12 years. To finance the project, the company needs to borrow $1.5 million today. The project will also produce intermediate cash flows, $150,000 of which HSI will use to service annual coupon payments (the coupons will actually be paid semi-annually as a payment of $75,000). Based on the risk of this investment, market participants will require a 10% yield. If HSI wishes a maturity of 12 years (matching the arrival of the lump sum cash flow), what does the face value of the bond have to be? (Recall that the compounding interval is 6 months and the YTM, like all interest rates, is reported on an annualized basis.) (Enter just the number without the $ sign or a comma, and no decimals.)
Answer for Question 9
Your Answer | Score | Explanation | |
1500000 | 15.00 | Correct.You appear to be fully conversant with the valuation of bonds. | |
Total | 15.00 / 15.00 |
Question Explanation
This is another example to make sure you understand and internalize the cash flow characteristics and pricing of bonds.
Question 10
(15 points) Two years ago, Motors, Inc. issued a corporate bond with an annual coupon of $4,000, paid at the rate of $2,000 every six months, and a maturity of 5 years. The par (face) value of the bond is $500,000. Recently, however, the company has run into some financial difficulty and has restructured its obligations.Today’s coupon payment has already been paid, but the remaining coupon payments will be postponed until maturity. The postponed payments will accrue interest at an annual rate of 3% per year and will be paid as a lump sum amount at maturity along with the face value. The discount rate on the renegotiated bonds, now considered much riskier, has gone from 5% prior to the renegotiations to 10% per annum with the announcement of the restructuring. What is the price at which the new renegotiated bond should be selling today? (Recall that the compounding interval is 6 months and the YTM, like all interest rates, is reported on an annualized basis.) (Enter just the number without the $ sign or a comma, and no decimals.)
Answer for Question 10
Your Answer | Score | Explanation | |
382405 | 15.00 | Correct. You know how to price a renegotiated bond and ignore irrelevant information. | |
Total | 15.00 / 15.00 |
Question Explanation
This question is a bit more challenging, and closer to the real world especially in today’s context. Same fundamental principles apply. Be careful, draw timeline and count number of remaining coupons.
Assignment 6
You have submitted this Assignment on Thu 6 Sep 2012 2:48:26 AM PDT. You achieved a score of 100.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. NOTE THAT DRAWING TIME LINES AND MAKING SURE THAT YOU HAVE THE TIMING OF CASH FLOWS RIGHT IS IMPORTANT.
Question 1
(5 points) Bonds require issuers to repay the principal (or face value) and (where applicable) precise coupon payments until contract maturity, while Equity requires the firm to pay a certain dividend in perpetuity.
Your Answer | Score | Explanation | |
False. | 5.00 | Correct. You understand the basics; which is more important than the details. | |
Total | 5.00 / 5.00 |
Question Explanation
Fundamentals of bonds and stocks.
Question 2
(5 points) Becky and Mandy are arguing about the best way to value the rapidly growing MySpaceBook.com. Mandy argues that, since MySpaceBook.com is young and will plow most of their earnings back into the company that the present value of all future earnings represents the best estimate of the stocks value. Becky disagrees. Who is right?
Your Answer | Score | Explanation | |
Becky | 5.00 | Correct. Understanding such apparently simple issues is really important. | |
Total | 5.00 / 5.00 |
Question Explanation
A fundamental question about stock valuation.
Question 3
(5 points) (One-period pricing. Recall that since stocks have really long lives, in the video we imagined owning a stock for only one period. In this simple, yet powerful scenario, today’s stock price is the PV of next year’s dividend and next year’s stock price. The formula was covered in class.) The stock for TM Consulting, and all-equity firm, is currently trading at $54 per share, after just having paid a $3 per share dividend. Management has not announced their specific dividend amount for next year, but they insist that they will pay a dividend. If analysts project the stock price to be $58 after next year’s dividend is paid out, and the equity cost of capital (also the discount rate for equity) is 15% for this firm, the expected dividend (for t = 1) must be closest to:
Your Answer | Score | Explanation | |
4 | 5.00 | Correct. You understand that changing the name of something does not make FV calculations difficult. | |
Total | 5.00 / 5.00 |
Question Explanation
Some simple mechanics and intuition for stock pricing; with some real-world application.
Question 4
(5 points) (One period stock pricing.) Julia’s Jewel Company (JJC) currently has a stock price of $42 per share. If JJC’s cost of equity capital (same as discount rate for equity) is 16% and the current dividend yield (DIV1/P0) is 6.25%, the expected price per share of the company in one year (t = 1) is closest to?
Your Answer | Score | Explanation | |
46 | 5.00 | Correct. You are able to fully grasp a simple equation, with deeper meaning. | |
Total | 5.00 / 5.00 |
Question Explanation
Again a simple formula that is deeper than most people think and needs to be understood clearly before proceeding further. Also, gives you an understanding of what the financial media is talking about.
Question 5
(10 points) Locked-In Real Estate (LIRE) is preparing for their Initial Public Equity Offering (IPO). With its holdings consisting of rent controlled apartments, and no plans for expanding, LIRE plans to payout all of its earnings as dividends. These dividends amount to $6 per share, forever. If the expected rate of return is 12%, what is the stock price of LIRE? (Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 5
Your Answer | Score | Explanation | |
50 | 10.00 | Correct. You know how to value an income stock. | |
Total | 10.00 / 10.00 |
Question Explanation
How to value an income stock. Simple, yet so powerful and useful.
Question 6
(10 points) Investments made from retained earnings that lead to increases in future earnings will always increase stock price.
Your Answer | Score | Explanation | |
False. | 10.00 | Correct. You appear to have internalized some fundamental issues. | |
Total | 10.00 / 10.00 |
Question Explanation
Sounds simple, but reflects a widely misunderstood issue.
Question 7
(15 points) You are deciding whether to add Pony Electronics to your portfolio, but you are concerned about your projection for their growth rate. Pony’s cost of equity capital (the discount rate for equity) is known to be 10% and they just paid a dividend of $1 per share. Most analysts are projecting constant growth of 8.25%, but you think that it might actually be 8.75%. By how much, in percentage terms, does this difference of opinion affect your estimate of Pony’s price per share relative to the estimate implied by the analysts’ forecast of growth rate? (No more than two decimals in the percentage difference, but do not enter the % sign.)
Answer for Question 7
Your Answer | Score | Explanation | |
40.65 | 15.00 | Correct. You know how to value a growth stock. | |
Total | 15.00 / 15.00 |
Question Explanation
The basics of the valuation of a growth stock; again simple but powerful.
Question 8
(15 points) GraceBook is a young firm that is in the process of creating a new web-based social media platform that is focused on the corporate market. While they are unable to pay any dividends today, once corporate contracts are awarded, they expect to be able to start paying a dividend of $2.00 per share beginning two years from now (t = 2). From that point forward, as they build their reputation and capacity, they expect to be able to increase their dividend each year at a constant rate. If GraceBook’s current stock price is $31 and their cost of equity capital (the discount rate for equity) is 9%, what is the growth rate implied by this price per share? (No more than two decimals in the percentage growth rate, but do not enter the % sign.)
Answer for Question 8
Your Answer | Score | Explanation | |
3.08 | 15.00 | Correct. You understand TVM in an unusual context, and can manipulate formulae. | |
Total | 15.00 / 15.00 |
Question Explanation
Pricing a growth stock with a realistic twist; and an important implied variable.
Question 9
(15 points) Supersoftware, Inc. earns a total of $100 million each year to pay out to their 4 million shareholders. They are in a very competitive business and have found it a struggle to come up with new ideas. They have however just uncovered a new innovation that will involve a one-time investment one year from now (t = 1) of $160 million for a system upgrade that will increase their cash flows by $20 million per year starting the following year (t = 2) in perpetuity. If Supersoftware’s cost of equity capital (the discount rate for equity) is 18%, by how much will this new idea change their price per share? (Draw time line to understand what is going on.) (Enter just the number without the $ sign or a comma; round off decimals.)
Answer for Question 9
Your Answer | Score | Explanation | |
-10 | 15.00 | Correct. You have a good grasp of the importance and measurement of value creation. | |
Total | 15.00 / 15.00 |
Question Explanation
This goes to the core of the process of value creation or destruction. Think through carefully and apply first principles; draw timeline and carefully think through what happens when.
Question 10
(15 points) Pisco, Inc., a technology company’s share price is $50 per share; earnings and dividends are $4 a share, and the growth rate is zero. The new management of the company thinks that it can grow even in a tough, competitive market. They have just announced a new growth strategy whereby the company’s earnings would begin growing by 3% per year and remain stable at this new rate. This new growth strategy will require the company to reinvest 40% if their earnings starting at the end of this year (t = 1). What will happen to the price per share of this company? (Think carefully, draw a time line.)
Your Answer | Score | Explanation | |
Decrease by $2. | 15.00 | Correct. You understand that value creation is needed for price to go up. | |
Total | 15.00 / 15.00 |
Question Explanation
The question goes to the core of value creation/destruction.
Assignment 7
You have submitted this Assignment on Wed 19 Sep 2012 12:58:52 PM PDT. You achieved a score of 90.00 out of 100.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. This assignment covers Statistics as related to finance. Refer to Note on Review of Statistics before you attempt this assignment. And feel free to use the statistical functions in Excel/Spreadsheets to calculate stuff.
Question 1
(5 points) Shareholders of Sparky’s Kerosene Company (SKC) face a variety of risks in holding SKC shares. If SKC purchases fire insurance for their factories, their shareholders will face lower
Your Answer | Score | Explanation | |
Specific/Idiosyncratic Risk. | 5.00 | Correct. You have a good intuition for fundamental types of risk. | |
Total | 5.00 / 5.00 |
Question Explanation
A fundamental question about different types of risks.
Question 2
(5 points) Suppose there are three securities (X, Y, and Z) to choose from, and next year the economy will be in an expansion, normal, or recession state with probabilities 0.30, 0.35, and 0.35,Y respectively. The returns (%) on the securitiies in these states are as follows: Security X {expansion = +10, normal = +8, recession = +6}; Security Y {+25,+10,-10}; Security Z {+7.5,+7.5,+7.5}. If the investor is risk neutral and must choose whether to invest in Security Y or Security Z, which would she buy?
Your Answer | Score | Explanation | |
Indifferent between Y & Z. | 5.00 | Correct. You know that she will choose based exclusively on expected returns | |
Total | 5.00 / 5.00 |
Question Explanation
This is a question that makes you calculate expected returns and, given the investor’s attitude toward risk, also asks you to make a choice on her behalf.
Question 3
(5 points) Suppose your dear old Grandfather approaches you for investment advice. He knows of your great training in finance and statistics and gives the following instructions: «Obviously, I want to maximize my returns, but since my life is now quite boring, I also enjoy a good thrill. My first priority is to pick the security with the highest return. After that, pick me the most volatile investment so I can enjoy the thrills of holding risk.» Suppose there are three securities (X, Y, and Z) to choose from next year, the economy will be in an expansion, normal, or recession state with probabilities 0.40, 0.20, and 0.40 respectively. The returns (%) on the securitiies in these states are as follows: Security X {expansion = +13, normal = +9, recession = +7}; Security Y,{+15,+15,+2}; Security Z {+17,+10,+2.5}. Which investment best fits your grandfather’s needs?
Your Answer | Score | Explanation | |
Security Z. | 5.00 | Correct. Once you see the calculations, his preferences determine the obvious choice. | |
Total | 5.00 / 5.00 |
Question Explanation
An exposure to how your choices depend on your risk prefereces.
Question 4
(10 points) Since investors are typically risk averse, they require a risk premium for any additional risk, regardless of source, that holding a security requires them to bear.
Your Answer | Score | Explanation | |
Total | 0.00 / 10.00 |
Question Explanation
Fundamental question about risk and diversification.
Question 5
(10 points) We often want to find investments that perform well when other parts of our portfolio are struggling. When considering stocks to add to the portfolio, those with a correlation closer to zero with our existing portfolio will most effectively help us diversify.
Your Answer | Score | Explanation | |
False. | 10.00 | Correct. You understand relationships and their critical role in diversification. | |
Total | 10.00 / 10.00 |
Question Explanation
Again, understanding relationships and diversification.
Question 6
(10 points) As a CEO you wish to maximize the productivity of your workers. You are thinking about providing your employees with smartphones so they can be readily available to clients and increase sales. However, you are also concerned that your employees are just as likely to download apps that will distract them from their work, leading them to play games and update their social networking sites rather than focus on the job of pleasing clients. To test this you randomly select 6 employees for an experiment. You provide 3 with the new smart phone and the other 3 use their existing technology. The following chart shows their changes in sales. Based on this small sample, what is the correlation between smartphone and increase in sales? [Hint: It may help to use the spreadsheet function CORREL to calculate the correlation. Also, enter the correlation is percentage terms with no more than two decimals, but do not enter the % sign.). ] {Anthony, Smartphone: Yes; change in sales 120; Kira, Smartphone No; Change in Sales 60; Michael, Smartphone No; Change in Sales 150; Scarlett., Smartphone Yes; Change in Sales 130; Pete, Smartphone Yes; Change in Sales 40; Angela, Smartphone No; Change in Sales 60.}
Answer for Question 6
Your Answer | Score | Explanation | |
8.03 | 10.00 | Correct. You know how to calculate/measure relationships. | |
Total | 10.00 / 10.00 |
Question Explanation
Calculation of correlation; important to finance and just about anything else.
Question 7
(10 points) Investors generally do not like to bear risk. Because of this, the price of an otherwise identical government bond relative to a corporate bond will be
Your Answer | Score | Explanation | |
Higher. | 10.00 | Correct. You will be willing to pay less for something that you dislike relative to the alternative. | |
Total | 10.00 / 10.00 |
Question Explanation
Simple pricing of risk-aversion.
Question 8
(15 points) Suppose your client is risk-averse but can invest in only one of the three securities, A, B, or C, in an uncertain world characterized as follows. Next year the economy will be in an expansion, normal, or recession state with probabilities 0.40, 0.40, and 0.20, respectively. The returns (%) on the three securities in these states are as follows: Security A {expansion = +12, normal = +10, recession = +7}; Security B {+11, +9, +8}; Security C {+12, +8, +7.5}. Which security can you rule out, that is, you will not advise your client to invest in it?
Your Answer | Score | Explanation | |
Security C. | 15.00 | Correct. You understand when an investment is dominated by others on the risk-return spectrum. | |
Total | 15.00 / 15.00 |
Question Explanation
This is a real life situation that requires you to think through a bit.
Question 9
(15 points) You have just taken over as a fund manager at a brokerage firm. Your assistant, Thomas, is briefing you on the current portfolio and states «We have too much of our portfolio in Alpha. We should probably move some of those funds into Gamma so we can achieve better diversification.» Is he right? [Hint: Feel free to use spreadsheet statistical functions.] Here is the data on all three stocks. Assume, for convenience, that all three securities do not pay dividends. Alpha, Current Price 40; Current Weight 80%; Next Year’s Price: Expansion 48, Normal 44, Recession 36; Beta, Current Price 27.50; Current Weight 20%; Next Year’s Price: Expansion 27.50, Normal 26, Recession 25; Gamma, Current Price 15; Current Weight 0%; Next Year’s Price: Expansion 18, Normal 16.50, Recession 13.50.
Your Answer | Score | Explanation | |
No. | 15.00 | Correct. You know how to calculate relationships and to make informed portfolio management decisions. | |
Total | 15.00 / 15.00 |
Question Explanation
A good question for figuring out portfolio composition given that we are into diversification.
Question 10
(15 points) Suppose there are two mortgage bankers. Banker 1 has two $1,000,000 mortgages to sell. The borrowers live on opposite sides of the country and face an independent probablity of default of 5%, with the banker able to salvage 40% of the mortgage value in case of default. Banker 2 also has two $1,000,000 mortgages to sell, but Banker 2’s borrowers live on the same street, have the same job security and income. Put differently, the fates and thus solvency of Banker 2’s borrowers move in lock step. They have a probability of defaulting of 5%, with the banker able to salvage 40% of the mortgage value in case of default. Both Bankers plan to sell their respective mortgages as a bundle in a mortgage-backed security (MBS) (i.e., as a portfolio). Which of the following is correct?
Question Explanation
A topical issue given the current crisis; requires you to both calculate and make decisions based on risk-return trade-offs.
Assignment 8
You have submitted this Assignment on Wed 19 Sep 2012 1:10:50 PM PDT. You achieved a score of 81.00 out of 86.00.
Top of Form
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. This assignment covers Statistics as related to finance. Refer to Note on Review of Statistics before you attempt this assignment. And feel free to use the statistical functions in Excel/Spreadsheets to calculate stuff.
Question 1
(5 points) By simply increasing the number of assets (e.g., assets > 30) in any portfolio, you can diversify your exposure to specific/idiosyncratic risk.
Your Answer | Score | Explanation | |
False. | 5.00 | Correct. You appear to understand the basics of diversification. | |
Total | 5.00 / 5.00 |
Question Explanation
Simple, basic question about risk.
Question 2
(10) You have an equally weighted portfolio that consists of equity ownership in three firms. Firm A is trading at $23 per share and has a beta of 1.15; Firm B is trading at $16 per share with a beta of 1.60; Firm C is trading at $76 per share with a beta of 0.85. Assume a risk free rate of 2% and market return of 7%. If each stock has a standard deviation of 40% and the stocks have a correlation of 0.20 with each other, your portfolio’s expected return is closest to
Your Answer | Score | Explanation | |
8% | 10.00 | Correct. You appear to understand expected returns of both securities and portfolios. | |
Total | 10.00 / 10.00 |
Question Explanation
To figure out the expected return on this, or any, portfolio. Important for making any type of investment decision.
Question 3
(10 points) You have a portfolio that consists of equity ownership in three firms. You own 200 shares of Euro General Stores (EGS), 450 shares of Fuerte Steel (FS) and 350 shares of Bamboo Flooring (BF). Their current share prices are $62, $73, and $12, respectively. What is the weight of FS in your portfolio? (No more than two decimals in the percentage weight, but do not enter the % sign.)
Answer for Question 3
Your Answer | Score | Explanation | |
66.43 | 10.00 | Correct. you know how to figure out relative investments implied by your choices. | |
Total | 10.00 / 10.00 |
Question Explanation
A simple question, but an important one to sort out as an investor.
Question 4
(10 points) With everyone nervous about their investments after the recent financial crisis, suppose a new firm, Safety Net Insurance (SNI), emerges to sell people insurance against poorly performing markets in exchange for an annual premium. As an investor in SNI, you would expect this company’s share to have a beta that is:
Your Answer | Score | Explanation | |
Negative. | 0.00 | Think again about what this «investment» provides you in a good versus bad state. | |
Total | 0.00 / 5.00 |
Question Explanation
Basic intuition of beta,, or systematic, risk.
Question 5
(10 points) Suppose there are three securities (A,B, and C) to choose from to create your portfolio.Next year the economy will be in an expansion, normal, or recession state with probabilities 0.30, 0.50, and 0.20, respectively. The returns (%) on the securitiies in these states are as follows: Security A {expansion = +8, normal = +7, recession = +2}; Security B {-1, -1, +5}; Security C {+14, +7, -8}. You are considering 4 potential portfolios of these 3 securities, with the following specific weights on each: Portfolio I (0.20, 0.40, 0.40); Portfolio II (0.34, 0.33, 0.33); Portfolio III (0.50, 0.25, 0.25); Portfolio IV (0.70, 0.15, 0.15); where the numbers in each parentheses are (weight of A, weight of B, weight of C). Which portfolio has the lowest risk?
Your Answer | Score | Explanation | |
Portfolio IV. | 1.00 | Correct. You know how to calculate the risk of a portfolio and hopefully program it in a spreadsheet. | |
Total | 1.00 / 1.00 |
Question Explanation
A question that makes you crunch the numbers so that you understand the risk of a portfolio and what it is determined by.
Question 6
(10 points) The PSI-20 is an index of the 20 largest market capitalization stocks traded on the Euronext Lisbon Stock Exchange in Portugal. You think that 20 stocks may not give you enough diversification, so you want to expand that list to the top 60 stocks. By doing this, what is the percentage increase in the UNIQUE relations between any two stocks in your portfolio that you will have to worry about? (No more than two decimals in the percentage drop, but do not enter the % sign.)
Answer for Question 6
Your Answer | Score | Explanation | |
831.58 | 10.00 | ||
Total | 10.00 / 10.00 |
Question Explanation
An important calculation to emphasize the importance of relations among stocks in a portfolio.
Question 7
(10 points) The CAPM states that the realized/actual return on an asset in any period will be the risk free rate plus beta times the market risk premium.
Your Answer | Score | Explanation | |
False. | 10.00 | Correct. You understand a simple but important difference. | |
Total | 10.00 / 10.00 |
Question Explanation
A simple, but widely misunderstood, difference between actual outcome(s) and the expected one in an uncertain world.
Question 8
(10 points) Suppose CAPM works, and you know that the expected returns on IBM and Google are estimated to be 11% and 9.5%, respectively. You have just calculated extremely reliable estimates of the betas of IBM and Google to be 1.25 and 0.95, respectively. Given this data, what is a reasonable estimate of the market risk-premium (the average/expected difference between the market return and the risk-free rate)? (No more than two decimals in the percentage return, but do not enter the % sign.)
Answer for Question 8
Your Answer | Score | Explanation | |
5 | 10.00 | Correct. You understand that linear relations (like the CAPM) are easy to work with. | |
Total | 10.00 / 10.00 |
Question Explanation
Testing your understanding of the CAPM and its key determinants.
Question 9
(10 points) The standard deviation of a portfolio’s return is the weighted average of the standard deviations of the returns of all securities in the portfolio, where the weights are proportional to the amount of your investment in a security relative to your total investment.
Your Answer | Score | Explanation | |
False. | 10.00 | Correct. You have internalized diversification and the relation between the risk of a portfolio and individual securities. | |
Total | 10.00 / 10.00 |
Question Explanation
Again, a basic but important, relation between the risks of portfolios and individual securities. Go back to basics.
Question 10
(15 Points) Your own company has been very successful in producing and selling rocket engines. Given that airplane engines are not that cheap, and the airline industry is extremely sensitive to the market, the beta of your company is 2.50. The market risk premium (the average/expected difference between the market return and the risk-free rate) is 4.00% and the return on a long-term government bond is 2.50%. You have discovered an exciting opportunity to create a new wireless device that will cover a whole state in the U.S. with one station. This project will require a $4 billion investment, spread out equally between now (t = 0) and the end of this year (t = 1), and will produce $500 million dollars in perpetuity starting in year 2 (t = 2). Should you proceed with this project?
Your Answer | Score | Explanation | |
Do not know. | 15.00 | Correct. You know that calculations without understanding the context are meaningless. | |
Total | 15.00 / 15.00 |
Question Explanation
An issue that is more important to valuation than any other.
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Assignment 9
You have submitted this Assignment on Thu 27 Sep 2012 3:27:40 AM PDT. You achieved a score of 85.00 out of 100.00.
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Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100.
Question 1
(5 points) In a world with no frictions (i.e., taxes, etc.), having debt is always better because it increases the value of the firm/project.
Your Answer | Score | Explanation | |
False. | 5.00 | Correct. You understand the irrelevance of financing. | |
Total | 5.00 / 5.00 |
Question Explanation
Fundamental question about value creation.
Question 2
(5) The return of equity is equal to the return on debt of a project/firm
Your Answer | Score | Explanation | |
Never true. | 5.00 | Correct. Equity is always riskier. | |
Total | 5.00 / 5.00 |
Question Explanation
Financing’s effects on equity.
Question 3
(10 points) Suppose the expected returns on equity of two firms, Macrosoft and Microsoft, that operate in the same industry are 10.50% and 12.60%, respectively. What is the return on assets in this business if Macrosoft has no debt? (No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 3
Your Answer | Score | Explanation | |
10.50 | 10.00 | Correct. You understand that return on assets in a business cannot vary for different forms. | |
Total | 10.00 / 10.00 |
Question Explanation
The effects of leverage on business risk.
Question 4
(10 points) Suppose CAPM holds, and the beta of the equity of your company is 2.30. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 5% and the risk-free rate is 3.25%. Suppose the debt-to-equity ratio of your company is 25% and the market believes that probability of default on your debt is zero. 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
Your Answer | Score | Explanation | |
12.45 | 10.00 | Correct. You know how to un-lever to obtain return on assets. | |
Total | 10.00 / 10.00 |
Question Explanation
Mechanics of calculating the return on assets.
Question 5
(10 points) You are planning on opening a consulting firm. You have projected yearly cash flows of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is 10%. The risk-free rate is 3.25% and the expected market risk premium (the average difference between between the market return and the risk-free rate) is 4.50%. What is the value of the cash flows of your business?
Your Answer | Score | Explanation | |
Do not have enough information to value. | 10.00 | Correct. You know what information you need to value. | |
Total | 10.00 / 10.00 |
Question Explanation
Understanding the valuation of a new business.
Question 6
(10 points) Your firm has been plodding along without much attention form the stock market; both analysts and investors are not showing much interest in your company. Your boss insists that (a) he can increase the return on equity of the company by simply taking on more debt and (b) that will attract new investors to the firm because of the higher returns.
Your Answer | Score | Explanation | |
Partly true; partly false. | 10.00 | Correct. You know how to critically evaluate a commonly made statement. | |
Total | 10.00 / 10.00 |
Question Explanation
A fundamental question about the role of financing in determining the characteristics of equity.
Question 7
(10 points) Two firms, ABC, Inc., and XYZ, Inc., are in the same business. XYZ, Inc., has debt that is viewed by the market as risk-less with a market value of $250 million. ABC, Inc., has no debt. Both firms are expected to generate cash flows of $50 million per year for the foreseeable future and the market value of the equity of ABC, Inc is $500 million. Estimate the return on equity of XYZ, Inc. Assume there are no taxes, and the risk-free rate is 4%. (No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 7
Your Answer | Score | Explanation | |
16.0 | 10.00 | Correct. You understand risk and return and the mechanics of calculating returns. | |
Total | 10.00 / 10.00 |
Question Explanation
A mechanical problem if you understand the effects of financing and use all information.
Question 8
(10 points) Mango, Inc. has had debt with market value of $1 million that has paid a 6% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $2 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 20%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)
Answer for Question 8
Your Answer | Score | Explanation | |
10000000 | 10.00 | Correct. You know how value is determined. | |
Total | 10.00 / 10.00 |
Question Explanation
An assessment of your ability to figure out the key determinants of value.
Question 9
(15 points) Suppose all investors are risk-averse and hold diversified portfolios. You are evaluating a new energy company that is going to use wind and will have two divisions: an electricity production unit and a Sales unit. [Transportation of the electricity will be outsourced.] Your CEO and you are arguing about whether projects that emerge in the two units should have the same cost of capital (WACC), or whether the discount rates should be different. If different, what should be the relative magnitudes of the discount rates, that is, which unit Production or Sales should have the higher discount rate. Assume the discount rates of the two units are labeled as P and S, for the production and Sales units, respectively. What do you think?
Your Answer | Score | Explanation | |
P>S. | 0.00 | Think again, a bit more deeply, about the nature of the risks of the two units. | |
Total | 0.00 / 15.00 |
Question Explanation
This is a crucial issue; much misunderstood in the real world (except by real value creators).
Question 10
(15 points) NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.25, 2.50, 2.75, and 3.00; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.21, 0.42, 0.63, 0.83. Although these D/E ratios vary, all airline debt is rated the same. Suppose the yield on airline debt is 7%, the risk-free rate is 3% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 5%. What is the cost of capital (or discount rate) that you should use in valuing NorthSouth Airlines? (No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 10
Your Answer | Score | Explanation | |
12.99 | 15.00 | Correct. You know how to carefully think through and calculate the costs of capital. | |
Total | 15.00 / 15.00 |
Question Explanation
This really tests you on how to think about and calculate the cost of capital in the real world.
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