2012 FM Slot2 MidTerm

Financial Markets

PGP/ABM/FPM I, Slot II, Mid-term Examination

Date: 13th September, 2012

Name: ________________________

Section: _____

Instructions

This is an open-book exam but only course textbook Brealey-Myers is allowed. Noother written material is allowed. Laptops, smart phones and tablets are also notallowed.

Please show your workings clearly. This will help you avail partial credits. If necessary, you may also attach extra sheets. Maximum Time: 2 hours

Indian Institute of Management, Ahmedabad

DXX

Mid-term Exam Financial Markets (2012) IIM, Ahmedabad

Question 1. When Marilyn Monroe died on August 5, 1962 (Sunday), ex-husband JoeDiMaggio vowed to place fresh flowers on her grave every Sunday starting August 12, 1962for as long as he lived. A bunch of fresh flowers that the former baseball player thoughtappropriate for the star cost about $5 when she died in 1962. If Joe expects to live foranother 30 years (i.e. expects to drop flowers for 30 years starting August 12), what is thepresent value of this commitment given that the annual interest rate, compounded weekly,is 10.4%, and the annual rate of inflation, compounded weekly, is 3.9%. Assuming that eachyear has exactly 52 weeks, and ignoring uncertainty around Joes life expectancy, what isthe present value of this commitment? [10]

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Question 2. Your niece is about to enter college and is confused about her career choices.She has two options open to her. Her first option is to study biochemsitry. If she does this,her degree would cost her 100, 000 a year for five years. Having obtained this, she plans toget two years of practical experience. In her first year she expects to earn 5 lacs from herjob, and in the second year 6 lacs. She then plans to get her post-graduate, which will costher 25, 000 a year for two years. After that she will be fully qualified and can hope to earn 18lacs per year for next 25 years. Her other alternative is to study psychology. If she does this,she would pay 40, 000 a year for four years and then she can expect to earn 12 lacs per yearfor next 30 years. You may assume the effort involved in the two careers is pretty much thesame, and for now she is only interested in the earnings the two careers provide. Assumingall earnings and costs are paid at the end of the year and interest rates are constant: [15]

a) What advice would you give her if the going bank interest rate is 8%?

b) A day later she comes back and says she took your advice, but in fact, the interest ratewas 9%. Has your niece made the right choice?

You may assume you are advising her as if she is starting college now.

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Question 3. The firm XYZ Inc. expects today to earn 4 per share for each of the futureoperating periods (beginning at time 1) if it makes no new investments and returns allearnings as dividends to the shareholders. However, you as a newly hired WIMWI graduatehave discovered an opportunity but that requires the firm to retain (and invest) 25% of itsearnings beginning the end of year 3. This opportunity to invest will continue for each periodindefinitely. You expect the firm to earn 40% (per year) on this new investment, the returnbeginning one year after each investment is made. The firms equity discount rate is 14%throughout. [20]

a) What is the price per share (now at time 0) of the XYZ stock if the company managementdoesnt listen to you and decides not to take up the new opportunity?

b) What if the management does listen to you and decides to go ahead with the investment- what would the price per share be now (at time 0)?

c) What part of the price in part b) is attributable to growth opportunities that you iden-tified?

d) What is the expected price at the end of one year if the proposed investment is made?What if the proposed investment is not made?

e) What is the dividend yield today (at time 0) if the new investment is made? What if thenew investment is not made?

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Question 4. Lio refinery has decided to suspend its dividends for the next two years. Itplans to resume its annual cash dividends of Rs. 2 a share three years from now. That is,no dividends at the end of next two years, and dividends resume only at the end of thirdyear from now. It plans to offer the same dividends at the end of fourth year too, and afterthat it plans to maintain an annual growth rate of 6% per year forever. Assuming thatthe required rate of return from Lio is 16%, what is the fair price of a Lio share given theDividend Discount Model. [5]

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Question 5. Consider a stock market which only consists of two securities. The amount ofshares and the price of each security are as follows: [25]

Security/Data Security A Security BQuantity 1000 500Price 100 180

The prospects (expected price) of the two stocks under different market conditions withattendant probabilities are as follows:

Expected Price of Securities under Different Market ConditionsMarket Condition Probability Security A Security BState 1: Very Good 0.10 125 225State 2: Good 0.40 120 207State 3: Bad 0.40 115 216State 4: Very Bad 0.10 110 198

a) What are the expected return and standard deviation of each security?

b) What are the covariances and correlations between the stocks A and B?

c) What are the expected return and standard deviation of the market portfolio?

d) If the bank rate of interest is given to be Rf , write the equation for the Capital MarketLine.

e) Do either of the two securities lie above the Capital Market Line? Why?

f) Is there any combination of the two securities that dominate the market portfolio? Why?

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Question 6. You are hired by Gold Sacks India, a major mutual fund player in the market.As part of your first assignment your boss has asked you to provide your view on twocompeting mutual funds and she has given you the following information: [20]

Fund-X Fund-YBeta () 0.8 1.2Standard Deviation () 20% 32%

Assuming CAPM holds and that you can borrow and lend at the bank rate (5%), and theexpected market risk premium (expected return from the market in excess of the bank rate)is 8%:

a) Which of the two mutual funds would you recommend to your boss if you can constructportfolios using either of the two funds and also borrow from/lend to the bank at 5%?

b) Continuing with part a) of the question above, what is the lowest risk portfolio that givesyou an expected return of 14.6%? What is its standard deviation?

c) Now suppose that bank charges you 2% more when you have to borrow compared towhen you deposit money. Assuming that the deposit rate is unchanged at 5%, does youranswer to part b) above change? How and why?

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Question 7. Stock of a company that you hold is expected to have a price of Rs. 100 a yearfrom now. Assuming CAPM holds and the company is not expected to pay any dividendsduring the year, how much would you be willing to sell it for today if the risk free rate is7%, expected return from the market is 15% and its beta () is 1.5? [5]

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2012 FM Slot2 MidTerm

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