FACULTY OF COMMERCE

DEPARTMENT OF FINANCE
MSC FINANCE AND INVESTMENTS
PART I 2ND SEMESTER FINAL EXAMINATION– MAY 2012
INVESTMENT ANALYSIS [CFI 5104]
TIME ALLOWED: 3 HOURS

INSTRUCTIONS TO CANDIDATES
1. Answer ANY FOUR (4) questions.
2. Write neatly and legibly.

INFORMATION TO CANDIDATES
1. The paper contains SIX (6) Questions.
2. Each full question carries a total of 25 marks and part marks are indicated in brackets at the
end of each part question.
3. Candidates may write on the question paper but shall not write in the answer booklet during
reading time.
4. The businesses in this question paper are intended to be fictitious

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QUESTION ONE [25 MARKS]
1.1 A pension fund manager is considering three mutual funds. The first is a stock fund, the
second is a long-term government and corporate bond fund, and the third is a T-bill
money market fund that yields a rate of 8%. The probability distribution of the risky
funds is as follows:
Expected Return Standard Deviation
Stock Fund (S) 20% 30%
Bond Fund (B) 12% 15%

The correlation between the fund returns is .10

(a) Solve numerically for the proportions of each asset and for the expected return and
standard deviation of the optimal risky portfolio. [3; 1; 2 marks]
(b) What is the reward-to-variability ratio of the best feasible capital allocation line
(CAL)? [2 marks]
(c) You require that your portfolio yield an expected return of 14%, and that it be
efficient, on the best feasible CAL.
(i) What is the standard deviation of your portfolio? [2 marks]
(ii) What is the proportion invested in the T-bill fund and each of the two risky
funds? [5 marks]
(d) If you were to use only the two risky funds, and still require an expected return of
14%, what would be the investment proportions of your portfolio? Compare its
standard deviation to that of the optimized portfolio in (c). What do you conclude?
[5 marks]

1.2 Create a well labeled diagram that clearly demonstrates how the optimal portfolio choice
of defensive investors differs from that of aggressive investors, given differential
borrowing and lending rates. [3 marks]

1.3 A portfolio has an expected rate of return of 20% and standard deviation of 30%. T-bills
offer a safe rate of return of 7%. Would an investor with risk-aversion parameter A=2
prefer to invest in T-bills or the risky portfolio? [2 marks]

QUESTION TWO [25 MARKS]

2.1 An investor’s portfolio currently is worth $1.5 million. During the year, the investor sells
1,500 shares of Stargate at a price of $120 per share and 3,000 shares of Moongate at a
price of $60 per share. The proceeds are used to buy 2,400 shares of Sungate at $150 per
share.

(a) What was the portfolio turnover rate? [2 marks]

(b) If Stargate shares originally were purchased for $105 each and those in
Moongate were purchased for $53, and the investor's tax rate on capital gains income
is 20%, how much extra will the investor owe on this year’s taxes as a result of these
transactions? [3 marks]

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2.2 Suppose that you sell short 500 shares of Litma, currently selling for $40 per share, and
give your broker $15,000 to establish your margin account.

(a) If you earn no interest on the funds in your margin account, what will be your rate of
return after one year if Litma’s stock is selling at (i) $44, (ii) $36? Assume that
Litma pays no dividends. Interpret your results. [5 marks]
(b) If the maintenance margin is 25%, how high can Litma’s price rise before you get a
margin call? [2 marks]
(c) Recalculate parts (a) and (b) but now assume that Litma also has paid a year-end
dividend of $1 per share. The prices in part (a) should be interpreted as ex-dividend.
[6 marks]

2.3 Provide two reasons why it is contended that bond-market indexes are more difficult to
construct and maintain than stock-market indexes. [2 marks]

2.4 Five years ago we invested $150,000 in a fund we thought would earn a geometric return
of 8% over a 20-year horizon so that at the end of the horizon we would receive
$699,143.57. During the past 5 years, however, the fund’s geometric return was only
6.5%. What must its geometric return be for the next 15 years if we are to reach our
original goal of $699,143.57? [2 marks]

2.5 In looking at the frequency distribution of weekly crude oil price changes between 1984
and 2008, an analyst notices that the frequency distribution has a surprisingly large
number of observations for extremely large positive price changes and a smaller number,
but still a surprising one, of observations for extremely large negative price changes. The
analyst provides you with the following statistical measures:
• Serial correlation of weekly price changes
• Variance of weekly price changes
• Skewness of weekly price changes
• Kurtosis of weekly price changes.

Which measures would help you identify these characteristics of the frequency
distribution? Briefly explain your answer. [3 marks]

QUESTION THREE [25 MARKS]

3.1 Jairos Phiri is a portfolio manager at NUST & Associates. For all of his clients, Phiri
manages portfolios that lie on the Markowitz efficient frontier. Phiri asks Bridgit James,
a managing director at NUST & Associates, to review the portfolios of two of his clients,
the Tiger Manufacturing Company and the Emporium Life Insurance Company. The
expected returns of the two portfolios are substantially different. James determines that
the Emporium portfolio is virtually identical to the market portfolio and concludes that
the Emporium portfolio must be superior to the Tiger portfolio.

(a) Do you agree or disagree with James’s conclusion that the Emporium portfolio is
superior to the Tiger portfolio? Justify your response with reference to the capital
market line. [4 marks]

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 (b) Phiri remarks that the Emporium portfolio has a higher expected return because it has
greater nonsystematic risk than Tiger’s portfolio. Define nonsystematic risk and
explain why you agree or disagree with Phiri’s remark. [4 marks]

3.2 Maria Khari, a portfolio manager at Noble Asset Management, is using the capital asset
pricing model for making recommendations to her clients. Her research department has
developed the information shown in the following exhibit.

Forecast Return, Standard Deviations, and Betas

Forecast Return Standard Deviation Beta
Stock X 14.0% 36% 0.8
Stock Y 17.0% 25% 1.5
Market index 14.0% 15% 1.0
Risk-free rate 5.0

(a) Compute the alpha for each stock. [3 marks]

(b) Identify and justify which stock would be more appropriate for an investor who wants to
(i) add this stock to a well-diversified equity portfolio. [1½ marks]
(ii) hold this stock as a single-stock portfolio. [1½ marks]
(c) Assume that the risk-free rate increases to 7% with the other data remaining unchanged.
Select the stock providing the higher expected risk-adjusted return and justify your
selection. [4 marks]

3.3 Suppose that two factors have been identified for the Utopia economy: the growth rate of
industrial production (IP), and the inflation rate (IR). IP is expected to be 3%, and IR
5%. A stock with a beta of 1.0 on IP and 0.5 on IR currently is expected to provide a rate
of return of 12%. If industrial production actually grows by 5%, while inflation rate turns
out to be 8%, what is your revised estimate of the expected rate of return on the stock.
[3 marks]
3.4 Suppose that the market can be described by the following three sources of systematic
risk with associated risk premiums.

Factor Risk Premium

Industrial production (I) 6%
Interest rates (R) 2%
Consumer confidence (C) 4%

The return on a particular stock is generated according to the following equation:

R = 15% + 1.0I + .5R + .75C + e

The T-bill rate is 6%.

Find the equilibrium rate of return on this stock using the APT. Is the stock over- or
under-valued? Explain. [4 marks]

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QUESTION FOUR [25 MARKS]
4.1 Prices of long-term bonds are more volatile than prices of short-term bonds. However,
yield-to-maturity of short-term bonds fluctuates more than yields of long-term bonds.
How do you reconcile the two empirical observations? [4 marks]

4.2 Naome Cramp, a fixed income portfolio manager based in the country of Gazania, is
considering the purchase of a Gazania government bond. Cramp decides to evaluate two
strategies for implementing his investment in Gazania bonds. Table 4A gives the details
of the two strategies and Table 4B contains the assumptions that apply to both strategies.

Table 4A – Investment Strategies (amounts are market value invested)

5-year Maturity 15-year Maturity 25-year Maturity
(Modified Modified (Modified
Strategy Duration=4.83) Duration=14.35) Duration=23.81)
I $5 million 0 $5 million
II 0 $10 million 0

Table 4B – Investment Strategy Assumptions

Market value of bonds $10 million
Bond maturities 5 and 25 years or 15 years
Bond coupon rates 0.00% (zero coupon)
Target modified duration 15 years

Before choosing one of the two bond investment strategies, Cramp wants to analyze how
the market value of the bonds will change if an instantaneous interest rate shift occurs
immediately after his investment. The details of the interest rate shift are shown in Table
4C.

Table 4C - Instantaneous Interest Rate Shift Immediately after Investment

Maturity Interest Rate Change
5 year Down 75 basis points (bps)
15 year Up 25 bps
25 year Up 50 bps

Required
Calculate, for the instantaneous interest rate shift shown in Table 4C, the percentage
change in the market value of the bonds that will occur after each strategy. [5 marks]

4.3 A client is reviewing a year-end portfolio report. Since the beginning of the year, market
yields have increased slightly. In comparing the beginning-of-the-year prices for the
bonds selling at a discount from par value to the end-of-the-year prices, the client
observes that all the prices are higher. The client is perplexed since he expects that the
price of all bonds should be lower since interest rates increased. Explain to the client
why the prices of bonds in the portfolio selling at a discount have increased in value.
[6 marks]

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4.4 How would you expect yield spreads to respond to the following macroeconomic events:
recession, high inflation, tax cuts, stock market decline, improved trade balance? Explain
the reasoning behind each of your answers. [10 marks]

QUESTION FIVE [25 MARKS]

5.1 Dynamic Research is initiating coverage of a mature manufacturing industry. Chris
Cross, head of the research department, gathered the following fundamental industry and
market data to help in his analysis:

Forecast industry earnings retention rate 40%

Forecast industry return on equity 25%
Industry beta 1.2
Government bond yield 6%
Equity risk premium 5%

(a) Compute the price-to-earnings (P/E) ratio for the industry based on this fundamental
data. [4 marks]
(b) Cross wants to analyse how fundamental P/E ratios differ among countries. He
gathered the following economic and market data:

Fundamental Factors Country A Country B

Forecast growth in real GDP 5% 2%
Government bond yield 10% 6%
Equity risk premium 5% 4%

Determine whether each of these fundamental factors would cause P/E ratios to be
generally higher for country A or higher for country B. [6 marks]

5.2 The following financial statements are extracted from the records of Cyclone
Corporation.
2007 2011
$000 $000
Income Statement Data
Revenues 542 797
Operating Income 38 76
Depreciation and amortization 3 9
Interest expense 3 0
Pretax income 32 67
Income taxes 13 37
Net income after tax 19 30
Balance Sheet Data
Fixed assets 41 70
Total assets 245 291
Working capital 123 157
Total debt 16 0
Total shareholders’ equity 159 220

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 Required
Decompose Cyclone’s return on equity using DuPont analysis. Further, discuss the
impact of changes in asset turnover and financial leverage on the change in ROE from
2007 to 2011. [7 marks]

5.3(a) An investor is considering the purchase of 100 ordinary shares in Webb Entertainments
PLC. Dividends from the shares will be paid annually. The next dividend is due in 6
months and is expected to be $1.60 per share. The second, third and fourth dividends are
expected to be 25% greater than their predecessors; thereafter dividends are expected to
grow at a constant rate of 5% per annum in perpetuity. Calculate the present value of the
dividends if the investor’s required rate of return is 14% per annum. [5 marks]

(b) Outline two weaknesses inherent in the Dividend Discount Model as a valuation approach.
[3 marks]

QUESTION SIX [25 MARKS]

6.1 An economy is making a rapid recovery from a steep recession, and businesses foresee a
need for large amounts of capital investment. Why would this development affect real
interest rates? [3 marks]

6.2 Briefly explain why the index of consumer expectations is a useful leading indicator of
the macroeconomy? [3 marks]

6.3 General Weedkillers Ltd dominates the chemical weed control market with its patented
product, Weed-ex. The patent is about to expire, however. What are your forecasts for
changes in the industry? Specifically, what will happen to industry prices, sales, the
profit prospects of General Weedkillers, and the profit prospects of its competitors? What
stage of the industry life cycle do you think is relevant for the analysis of this market?
Explain your answer. [8 marks]

6.4 Despite the arguments and evidence offered by proponents of market efficiency, many
investors pay attention to technical analysis in some form. Speculate as to why these
investors use this kind of investment research. [6 marks]

6.5 “The behavior of stock prices can be likened to the walk of a drunken person.” Respond.
[5 marks]

END OF EXAMINATION PAPER

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