Finance Question - Fin 12 Midterm

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Fin 12 Midterm #2

 

 

 

Questions 1, 2, and 3 are worth 30 points.  Question 4 is worth 10 points.

 

 

 

1.                   A stock paid a dividend of $2 last period and its growth rates are forecast to be for the first period and for every period thereafter.  The stock has a systematic risk of 1.5, the return on the market portfolio is 12% and the risk free rate of return is 4%. 

 

 

 

  1. Determine the cash flows for the first three periods.

     

  2. Determine the required rate of return for the stock using the CAPM.

     

  3. Determine the value of this stock.

     

  4. Suppose that the stock is trading for $15.  Would you want to buy it or sell it or are you indifferent?  What is the NPV of buying the stock?  

     

  5. Graph the security market line and show where this stock’s return falls relative to its equilibrium rate of return.  (It is not necessary to determine the current rate of return on this stock.)

     

 

 

2.                   Cincinnati Express is a small regional airline.  To open a new route, the airline must buy two commuter airplanes at an estimated cost of $3m each, after tax.  Other start-up costs are expected to be $500,000 after-tax.  Annual operating costs are expected to be $600,000 per year after-tax.  Costs are largely fixed, and do not depend on revenue.  As with many new routes into small towns, demand is uncertain until the service has actually been offered.  Demand after the first year is expected to be very similar to that in the first year.  A discrete probability distribution for revenue is shown in the table below;

 

 

 

Probability

 

.1

 

.2

 

.4

 

.2

 

.1

 

Revenue (after tax)

 

700,000

 

900,000

 

1,200,000

 

1,500,000

 

2,000,000

 

 

 

If the route turns out to be unprofitable, the airplanes can be sold for an estimated market value of $2.5m at the end of the first year.  The airplanes will last approximately 10 years, after which they will have an estimated salvage value of $250,000.  A 10-year horizon is used for decision making.

 

 

 

3.                  Suppose that you have the following data on states of nature and outcomes for three securities:

 

 

 

State                 Prob.                RA                    RM                   RF

 

I                       0.6                   14%                 12%                 4%

 

II                      0.4                   -2%                  3%                   4%

 

 

 

  1. Find the expected return and standard deviation for each security.

     

  2. Find the covariance between A and M.  Then, find the correlation between A and M.

     

  3. Given the correlation between A and M, is it useful to form a portfolio using these two assets?  Explain.

     

  4. Form a portfolio by allocating 40% of your wealth to A and the remainder to M.  Compute the expected return and standard deviation of this portfolio.  Compare the standard deviation to a weighted average standard deviation for A and M.  Explain why the portfolio standard deviation is either the same as or lower than the weighted average standard deviation.

     

 

 

 

4.                  What is a “real option” and how does it relate to capital budgeting and the objective of the firm?

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