Question 1

In the following, different parts of the question are independent and not related to
each other.

(a) Suppose that the effective semi-annual risk-free interest rate is 3%. Consider a risk-free
security that pays $4,000 in year 1, $5,000 in year 2 and $6,000 in year 3. Note that there
is no risk associated with the cash flows. Find the fair value today of the security.

(b) Consider an effective monthly interest rate of 2%. Find the equivalent continuously
compounded rate. If you invest $2.5 million at this equivalent continuously compounded
rate for 13.2 years, how much fund will you end up with in 13.2 years?

(c) Suppose that an investor can invest in the following stocks with the expected annual
returns and annual return volatilities (both are expressed in percentage terms) shown in
the table below

Stock Expected Annual Return Annual Return Volatility

A 10 20
B 30 55
C 20 20
D 30 35
E 10 22
F 15 23
H 30 5
I 20 15
J 15 18

The following question refers to an investor choosing to invest in one of the stocks
mentioned. The investor cannot invest in both, he or she has to choose one of the two
stocks.
(i) If a risk averse investor has a choice between investing either in Stock A or
Stock E, which one would the investor choose? Briefly explain your answer.

(ii) A risk-loving investor has a choice between investing either in Stock C or Stock
I, which one would the investor choose? Briefly explain your answer.

(iii) A risk-neutral investor has a choice between investing either Stock A or Stock B,
which one would the investor choose? Briefly explain your answer.

(iv) Among all the stocks listed in the table above, which is the most preferred stocks
by a risk-averse investors. Briefly explain your answer.

(v) Among all the stocks listed in table above, which is the most preferred stocks by
a risk-loving investors. Briefly explain your answer.
 (5 + 5 + 15 = 25 marks)
(a)

C2 C4 C6 4K 5K 6K
V0 = + + = + + = 13, 237.7244
(1 + r ) (1 + r ) (1 + r ) (1.03) (1.03) (1.03)
2 4 6 2 4 6
f f f
3770.3836 4442.4352 5024.9055

(1 + rA ) = (1 + r ) = erc  (1.02 ) = erc  rc = ln (1.0212 ) = 0.2376 = 23.76%

m 12
(b)

V13.20 = X oetrc = 2.5e13.200.2376 = 57.5475

(c) Note that all investors type like higher expected return compared to lower
expected return.

(i) Stock A, because Stock A and Stock E have the same expected annual return, Stock A has
lower volatility of 20% instead of 22% for Stock E and risk-averse investors dislike risk or higher
volatility.

(ii) Stock C, because Stock C and I have the same expected return (20%), but Stock C has
higher volatility (20%) instead of Stock I (15%) and risk-loving investor prefer higher volatility.

(iii) Stock B, because Stock B has higher expected return (30%) compared to Stock
A (10%) and risk-neutral investors does not care about risk (risk or volatility is
completely ignored).

(iv) Stock H, because it has the highest expected return and lowest risk. Stock D and
Stock B also have highest expected return but these stocks have higher volatilities
compared to Stock H. Note that risk-averse investors like higher expected return and
lower risk or volatility.

(v) Stock B, because it has the highest expected return and highestt volatility. Stock
D and Stock H also have highest expected return but these stocks have lower volatilities
compared to Stock H. Note that risk-loving investors like higher expected return and
higher risk or volatility.
Question 2

In the following, different parts of the question are independent and not related to
each other.

(a) Consider a stock of ABC Corporation whose CAPM beta is 2.5. The expected annual
return on the market is 12.25% and the annual risk-free rate is 2.5%. The annual volatility
of the market is 22.55% and the annual volatility of the stock is 62.33%. Find the annual
cost-of-capital for the stock and the correlation between the return on the market and the
ABC Corp. stock.

(b) Suppose that the cost-of-capital for Stock A and Stock B are is 15.71% and 12.27%
respectively. The CAPM beta of Stock A is 1.25 and the expected return on the market is
13.25%. Find the CAPM beta of Stock B and risk-free interest rate.

(10 + 15 = 25 marks)

(a) ki = rf + i ( m − rf ) = 0.025 + 2.5 ( 0.1225 − 0.025) = 0.26875

 im im i  2.5  0.2255
i = =  im = i m = = 0.9045 = 90.45%
m2
m i 0.6233
Therefore, the correlation is 90.45%.

(b)
ki = rf + i ( m − rf )
0.1571 = rf + 1.25 ( 0.1325 − rf )  0.1571 = rf (1 −1.25) + 1.25  0.1325
0.1571 − 1.25  0.1325
rf = = 0.0341 (risk-free rate 3.41%)
(1 − 1.25)

ki = rf + i ( m − rf )
0.1227 = rf + B ( m − rf )  0.1227 = 0.0341 + B ( 0.1325 − 0.0341)
0.1227 − 0.0341
B = = 0.9004
(0.1325 − 0.0341)
Question 3

In the following, different parts of the question are independent and not related to
each other.

(a) Consider Project H and Project I whose cash inflows and outflows are shown in table
below. The cost-of-capital for Project H is 19.50% and the cost-of-capital for Project I is
18.50%.

Project H Project I
Year Cash Outflow Cash Inflow Cash Outflow Cash Inflow
0 12 0 14 0
1 0 6 0 6
2 0 7 0 6
3 2 8 3 7
4 0 9 0 8

i. Find the fair value of each project. If you can accept only one of the two projects, which
one would you choose?

ii. What should be the cash inflow of Project I in year 4 so that the fair values of the projects
H and I are the same?

(b) Consider a 210-day commercial paper with face value of $100 thousand that is trading at
a price of $95.52 thousand. Compute the discount yield.

(18 + 7 = 25 marks)

6 7 6 9
(a.i.) VH = −12 + + + + = 5.8522
1.195 1.195 1.195 1.1954
2 3

6 6 4 8
VI = −14 + + + + = 1.7971
1.185 1.185 1.185 1.1854
2 3

−2.2601

Choose Project H due to higher fair value.

(a.ii) Here, you want to solve the following for C4
 6 6 4 C4
−14 + + + + = 5.8522
1.185 1.185 1.185 1.1854
2 3

−2.2601

C4 = ( 5.8522 + 2.2601) 1.1854 = 15.9961

 h   210 
(b) P0 = F 1 − idy    95.52 = 100 1 − idy  
 360   360 

Therefore,

 95.52  360
idy = 1 − = 0.0768 = 7.68%
 100  210
Question 4

In the following, different parts of the question are independent and not related to
each other.

(a) A stock is expected to pay $2.54 as dividend in one year. The dividend is expected to
grow at a rate of 12% per year for ever. Find the fair value of the stock today if the annual
cost-of-capital is 10%. Assume that the stock pays annual dividend. Do you expect such
stock to exist in the market? Briefly explain your answer.

(b) Consider a stock that pays quarterly (every 3 months) dividends. The next dividend is
expected to be paid in 3 months and is expected to be $1.5 per share. The quarterly
dividend is expected to be constant for the next four years. After 4 years, the quarterly
dividend is expected to be constant at $2.0 per share for the next three years (years 5, 6
and 7) after that the quarterly dividend is expected to grow at 1.5% for ever. The effective
quarterly cost-of-capital is 4.5%. The effective semi-annual cost-of-capital is 7.125% and
the effective annual cost-of-capital is 31.68%. Find the fair value of the stock today.

(7 + 18 = 25 marks)
(a) g  k , V0 =  . Since the growth rate is higher than the cost-of-capital, the value of this
stock is infinite. Such stock is not expected to exists in real world.

C1  1  1 C2  1  1 C2 (1 + g )
(b) V0 = 1 − n1 
+ 1 − n2 
+
k  (1 + k )  (1 + k ) k  (1 + k )  (1 + k )
n1 n1 + n2
k−g

1.5  1  1 2  1  1 2.0 (1 + 0.015)

V0 = 1 −  + 1 − 12 
+
0.045  (1 + 0.045)  (1 + 0.045) 0.045  (1 + 0.045 )  (1 + 0.045 ) 0.045 − 0.015
16 16 28

16.85102 9.017717 19.72962

V0 = 45.59836

Alternate,

1.5  1  1 2  1  1 2.0
V0 = 1 − 16 
+ 1 − 11 
+ = 45.59836
0.045  (1 + 0.045)  (1 + 0.045 ) 0.045  (1 + 0.045 )  (1 + 0.045 )27 0.045 − 0.015
16

16.85102 8.4346 20.3128

Please see the next page for explanation

The cash flow looks like the following

Chart Title
2.5
2 2 2 2 2 2 2 2 2 2 2 2 2.03 2.06 2.09 2.12
2
1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5
1.5

0.5

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32

Year 1 year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

The first solution considers three terms (i) 16-period annuity (with payment 1.5), (ii) 12-period annuity (with payment 2.0) delayed by 16 periods
plus (iii) growing perpetuity starting from period 29 assuming you are at the end of period 28 so 𝐷1 = 2 × 1.015 = 2.03

1.5  1  1 2  1  1 2.0 (1 + 0.015)

V0 = 1 − 16 
+ 1 − 12 
+ = 45.59836
0.045  (1 + 0.045)  (1 + 0.045) 0.045  (1 + 0.045 )  (1 + 0.045 ) 0.045 − 0.015
16 28

16.85102 9.017717 19.72962

The second solution considers three terms (i) 16-period annuity (with payment 1.5), (ii) 11-period annuity (with payment 2) delayed by 16
periods plus (iii) growing perpetuity starting from period 28 assuming you are at the end of period 27 so 𝐷1 = 2.

1.5  1  1 2  1  1 2.0
V0 = 1 − 16 
+ 1 − 11 
+ = 45.59836
0.045  (1 + 0.045)  (1 + 0.045 ) 0.045  (1 + 0.045 )  (1 + 0.045 ) 0.045 − 0.015
16 27

16.85102 8.4346 20.3128