Makeup Exam MØA 155 Financial Economics February 2010 Permitted Material: Calculator, Norwegian/English Dictionary

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1 University of Stavanger (UiS) Stavanger Masters Program Makeup Exam MØA 155 Financial Economics February 2010 Permitted Material: Calculator, Norwegian/English Dictionary The number in brackets is the weight for each problem. The weights sum to 100. YOU MAY ANSWER IN ENGLISH OR NORWEGIAN. Some advice: It is better to try to do something on each question than to get bogged down with one question. None of these questions requires a lot of complicated calculations. If you find you are spending too much time on one question, stop working on it and plan to get back to it if you have time at the end. Make sure you state any assumptions you make. Explain and show the steps of any calculations you do. Keep discussions clear and brief. You will be rewarded for answers emphasizing intuition. Exercise 1. Compounding. [10] For an investment of $1,000 today, the Tiburon Finance Company is offering to pay you $1,600 at the end of 8 years. 1. What is the annually compounded rate of interest? 2. What is the continuously compounded rate of interest? Exercise 2. Investments [10] You must choose between 1. spending $80 now to receive $130 in 12 months or 2. spending $35 now to receive $70 in 12 months. 1. At what interest rate would you be indifferent between these two alternatives? 2. Which project has the higher rate of return? 3. How can you reconcile your answers to these two questions? Exercise 3. [5] Stocks in company A is priced at 100. Next year s dividend payment is expected to be 10 per stock. The firm s dividend payments are expected to increase by 10% from one year to the next. 1

2 1. Using the dividend discount model, what is the implicit discount rate used in valuing this stock? Exercise 4. Project [5] A project is planned to give the following cash flows for the next 4 years: t = C t = The project requires an initial investment of The relevant (annually compounded) interest rate is 14%. Disregard taxes. 1. Should you invest in this project? Exercise 5. Treasuries [5] A treasury zero coupon bill that pays 100 one period from now is priced at 95. A treasury zero coupon bill that pays 100 two periods from now is priced at Determine the price of a two year treasury bond. The bond has a face value of 1000, and pays 10% annual interest. Exercise 6. [10] Consider an investor that puts together a portfolio based on the following properties of the investment portfolio: 1. Expected return E[r p ]. 2. variance of return σ 2 (r p ). I.e. the investor has a utility function U(E[r p ], σ 2 (r p )). This investor has access to two possible investment opportunities A and B, with the given expected returns and standard deviations: E[r i ] σ(r i )) A 8% 20% B 10% 30% 1. Suppose an investor can only invest in one of the assets. Is it possible to specify which stock a risk averse investor will choose? Exercise 7. XZY [10] The current price of XZY stock is 50. XZY is not expected to pay dividends the next few years. It has a cost of equity capital of 10% and a cost of debt capital of 5%. The beta of the equity is one, and the market risk premium is 6%. Interest rates are stated with annual compounding. Disregard taxes. 1. What interest rate would XZY company use to evaluate an expansion of its existing business? The expansion is planned to be financed with 60% debt. 2

3 Exercise 8. Analyst [10] A stock has a beta of 0.9. A security analyst who specializes in studying this stock expects its return to be 13%. Suppose the risk free rate is 8% and the market risk premium is 6%. 1. Is the analyst pessimistic or optimistic about this stock relative to the markets expectation? Exercise 9. Coffee [10] Suppose you are aware of the following investment opportunity: You could open a coffee shop around the corner from your home for $25,000. If business is strong, you could net $15,000 in after-tax cash flows each year over the next 5 years. 1. If you knew for certain the business would be a success, would this be a risky investment? 2. Now assume this is a risky venture and there is a 50% chance it is a success and a 50% chance you go bankrupt within 2 years. You decide to invest. If the business subsequently go bankrupt, did you make the wrong decision based on the information you had at the time? Why or why not? Exercise 10. Short answer questions [20] Please give short answers/discussions of the following questions. 1. When first issued, a stock provides funds for a company. Is the same true for a stock option, such as the put or call options traded on the Oslo Stock Exchange? 2. A company knows it is due to receive a certain amount of foreign currency in 4 months. What type of option contract is appropriate for hedging? 3. Discuss the statement Risk management with financial instrument is the same as gambling in the financial markets, it just depend on context. 4. Discuss the statement When volatility increases, both put and call options become more valuable. 5. Discuss the statement Miller and Modigliani show that the future dividends of the firm do not matter for the value of the firm. 6. On February 5, 2010, the spot exchange rate between US dollars (USD) and Norwegian crowns (NOK) is On the same date, the corresponding three month forward rate USD/NOK is If the expectations hypothesis holds, what does the market expect about the future spot price? 3

4 Exercise 11. Engel [10] Assume one of only two states will exist one year from today, when a call on Engel, Inc., stock expires. With equal probability, the price of Engel stock will be either $75 or $50 on that date. Today, Engel stock trades for $60. The strike price of the call is $60. The rate at which you can borrow is 9%, annually compounded. 1. How much are you willing to pay for a contract of this call? 4

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