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Project C0 C1 C2 C3 C4 C5
A (1,000) 1,000 0 0 0 0
B (2,000) 1,000 1,000 4,000 1,000 1,000
C (3,000) 1,000 1,000 0 1,000 1,000
Answer:
Project A:
NPV = 909-1,000
NPV = (91)
Project B:
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NPV = Present Value – Initial Cost
NPV = 6,043-2,000
NPV = 4,043
Project C:
NPV = 3,039-3,000
NPV = 39
iii) If cutoff period is 3 years then firm will select project A&B.
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Question No.2: Consider the following three stocks:
Answer:
a) Stock A:
a) Stock B:
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c) Stock C:
Note: If the market capitalization rate is 10% then stock A is the most valuable
stock.
b) Stock A:
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b) Stock B:
b) Stock C:
(P0) = 5/(1+.07)+6/(1+.07)2+7.2/(1+.07)3+8.64/(1+.07)4+10.36+12.44/(1+.07)5
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Question No.3 (a): The total market value of the common stock of the
Alfalah Real Estate Company is Rs.6 million and the
total value of its debt is Rs.4 million. The treasurer
estimates that the beta of the stock is currently 1.5 and
the expected risk premium on the market is 9 percent.
The Treasury bill rate is 8 percent.
Answer:
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iii) Risk free rate (Rf) = 8%
Question No.3 (b): Suppose that there is no relation between beta and
expected returns. Do you think that beta is an
uninteresting statistic? What would you do as an
investor? What strategies should a corporation adopt?
Answer:
The CAPM is a model for pricing an individual security (asset) or a portfolio. For
individual security perspective, we made use of the security market line (SML)
and its relation to expected return and systematic risk (beta) to show how the
market must price individual securities in relation to their security risk class. The
SML enables us to calculate the reward-to-risk ratio for any security in relation to
the overall market’s. Therefore, when the expected rate of return for any security
is deflated by its beta coefficient, the reward-to-risk ratio for any individual
security in the market is equal to the market reward-to-risk ratio, thus:
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The market reward-to-risk ratio is effectively the market risk premium and by
rearranging the above equation and solving for E(Ri), we obtain the Capital Asset
Pricing Model (CAPM).
Where:
returns, or also ,
• is the expected return of the market
• Is sometimes known as the market premium or risk
premium (the difference between the expected market rate of return and
the risk-free rate of return). Note 1: the expected market rate of return is
usually measured by looking at the arithmetic average of the historical
returns on a market portfolio (i.e. S&P 500). Note 2: the risk free rate of
return used for determining the risk premium is usually the arithmetic
average of historical risk free rates of return and not the current risk free
rate of return.
Asset Pricing:
Once the expected return, E(Ri), is calculated using CAPM, the future cash flows
of the asset can be discounted to their present value using this rate (E(Ri)), to
establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is the
same as its value calculated using the CAPM derived discount rate. If the
observed price is higher than the valuation, then the asset is overvalued (and
undervalued when the observed price is below the CAPM valuation).
Alternatively, one can "solve for the discount rate" for the observed price given a
particular valuation model and compare that discount rate with the CAPM rate. If
the discount rate in the model is lower than the CAPM rate then the asset is
overvalued (and undervalued for a too high discount rate).
The CAPM returns the asset-appropriate required return or discount rate - i.e. the
rate at which future cash flows produced by the asset should be discounted given
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that asset's relative riskiness. Betas exceeding one signify more than average
"riskiness"; betas below one indicate lower than average. Thus a more risky
stock will have a higher beta and will be discounted at a higher rate; less
sensitive stocks will have lower betas and be discounted at a lower rate. The
CAPM is consistent with intuition - investors (should) require a higher return for
holding a more risky asset.
The risk of a portfolio comprises systemic risk and specific risk which is also
known as idiosyncratic risk. Systemic risk refers to the risk common to all
securities - i.e. market risk. Specific risk is the risk associated with individual
assets. Specific risk can be diversified away to smaller levels by including a
greater number of assets in the portfolio. (Specific risks "average out");
systematic risk (within one market) cannot. Depending on the market, a portfolio
of approximately 30-40 securities in developed markets such as UK or US (more
in case of developing markets because of higher asset volatilities) will render the
portfolio sufficiently diversified to limit exposure to systemic risk only.
A rational investor should not take on any diversifiable risk, as only non-
diversifiable risks are rewarded within the scope of this model. Therefore, the
required return on an asset, that is, the return that compensates for risk taken,
must be linked to its riskiness in a portfolio context - i.e. its contribution to overall
portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM
context, portfolio risk is represented by higher variance i.e. less predictability. In
other words the beta of the portfolio is the defining factor in rewarding the
systemic exposure taken by an investor.
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private placement would be 9 percent, but the total
issuing expense would be only Rs.30,000.
a) What is the difference in the proceeds to the
company net of expenses?
b) Other things equal, which is the better deal?
c) What other factors beyond the interest rate
and issue cost would you wish to consider
before deciding between the two offers?
Answer:
a) Net Proceeds:
Net Proceeds = Face value – underwriting & other exp.
i) Net Proceed of public issue (offer A) = 10,000,000-150,000-80,000
Net Proceed of public issue (offer A) = Rs.9,770,000
= 0.005 x 10,000,000/(1.085)t
= Rs.328,000
Extra cost of Rs.328,000 of higher interest on Pvt. Placement more than
outweighs saving in issue. Cost N.b. we ignore taxes.
Question No.5 (a): What are the main differences between corporate debt
and equity? Why do some firms try to issue equity in the
guise of debt?
Answer:
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Sometimes, the term "corporate bonds" is used to include all bonds except those
issued by governments in their own currencies, although, strictly speaking, it only
applies to those issued by corporations (those which are subsumed by neither
category include the bonds of local authorities and supranational organizations).
Corporate bonds are often listed on major exchanges (such bonds being
described as "listed" bonds) and ECNs like Market Acess, and the coupon (i.e.
interest payment) is usually taxable. However, despite being listed on exchanges,
the vast majority of trading volume in corporate bonds in most developed
markets takes place in decentralized, dealer-based, over-the-counter markets.
Corporate debt is securities short and long term debt issued by corporate.
Short term debt is issued as commercial paper. Long term debt is issued as
bonds/notes. Issuers place paper in their own domestic market or they may
widen their investor base by issuing in a foreign market or in the international
market - the Euro market - in any number of currencies.
Shareholders are owners of the company and receive returns (dividends) related
to the company’s profitability.
Holders of debt securities are creditors of the company. Their return is a fixed
rate of interest paid regularly until the loan is re-paid at maturity by the company.
As creditors, holders of debt securities rank higher than shareholders in the event
of company liquidation. This means they receive their money back before
shareholders if the company is liquidated.
Holders of debt securities carry a lower risk than shareholders, because they
have a guaranteed stream of income in the form of interest payments. Therefore
the return on debt securities can be lower than the return from shares.
Holders of debt securities are re-paid their investment at a set date whereas
shares have no fixed maturity. Shareholders decide when they no longer want to
be an investor in the company, sell the shares and accept the prevailing market
price.
Corporate Equity:
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1. The residual value of a business or property beyond any mortgage
thereon and liability therein.
2.
a. The market value of securities less any debt incurred.
b. Common stock and preferred stock.
3. Funds provided to a business by the sale of stock.
In the United Kingdom, the word stocks refer to a completely different financial
instrument: the bond. It can also refer more widely to all kinds of marketable
securities. The term "share" still means the stock issued by a corporation,
however. These definitions also hold true for Australia.
Type of Stocks:
Common Stock:
Preferred Stock:
Preferred stock, sometimes called preference shares, have priority over common
stock in the distribution of dividends and assets.
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Dual Class Stock:
Dual class stock is shares issued for a single company with varying classes
indicating different rights on voting and dividend payments. Each kind of shares
has its own class of shareholders entitling different rights.
Treasury Stock:
Treasury stock is shares that have been bought back from the public. Treasury
Stock is considered issued, but not outstanding.
Stock Derivatives:
A stock derivative is any financial claim which has a value that is dependent on
the price of the underlying stock. Futures and options are the main types of
derivatives on stocks. The underlying security may be a stock index or an
individual firm's stock, e.g. single-stock futures.
Stock futures are contracts where the buyer, or long, takes on the obligation to
buy on the contract maturity date, and the seller, or short takes on the obligation
to sell. Stock index futures are generally not delivered in the usual manner, but
by cash settlement.
A stock option is a class of option. Specifically, a call option is the right (not
obligation) to buy stock in the future at a fixed price and a put option is the right
(not obligation) to sell stock in the future at a fixed price. Thus, the value of a
stock option changes in reaction to the underlying stock of which it is a derivative.
The most popular method of valuing stock options is the Black Scholes model.
Shareholder:
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value after a bankruptcy if there is the possibility that the debts of the company
will be restructured.
Although directors and officers of a company are bound by fiduciary duties to act
in the best interest of the shareholders, the shareholders themselves normally do
not have such duties towards each other.
However, in a few unusual cases, some courts have been willing to imply such a
duty between shareholders. For example, in California, majority shareholders of
closely held corporations have a duty to not destroy the value of the shares held
by minority shareholders.
Application:
The owners of a company may want additional capital to invest in new projects
within the company. They may also simply wish to reduce their holding, freeing
up capital for their own private use.
By selling shares they can sell part or all of the company to many part-owners.
The purchase of one share entitles the owner of that share to literally share in the
ownership of the company a fraction of the decision-making power, and
potentially a fraction of the profits, which the company may issue as dividends.
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Shareholder rights:
In most countries, including the United States, boards of directors and company
managers have a fiduciary responsibility to run the company in the interests of its
stockholders. Nonetheless, as Martin Whitman writes:
"...it can safely be stated that there does not exist any publicly traded
company where management works exclusively in the best interests of
OPMI [Outside Passive Minority Investor] stockholders. Instead, there are
both "communities of interest" and "conflicts of interest" between
stockholders (principal) and management (agent). This conflict is referred
to as the principal/agent problem. It would be naive to think that any
management would forego management compensation, and management
entrenchment, just because some of these management privileges might
be perceived as giving rise to a conflict of interest with OPMIs."
Even though the board of directors runs the company, the shareholder has some
impact on the company's policy, as the shareholders elect the board of directors.
Each shareholder typically has a percentage of votes equal to the percentage of
shares he or she owns. So as long as the shareholders agree that the
management (agent) is performing poorly they can elect a new board of directors
which can then hire a new management team. In practice, however, genuinely
contested board elections are rare. Board candidates are usually nominated by
insiders or by the board of the directors themselves, and a considerable amount
of stock are held and voted by insiders.
Owning shares does not mean responsibility for liabilities. If a company goes
broke and has to default on loans, the shareholders are not liable in any way.
However, all money obtained by converting assets into cash will be used to repay
loans and other debts first, so that shareholders cannot receive any money
unless and until creditors have been paid (most often the shareholders end up
with nothing).
Means of financing:
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capital (day-to-day operational needs). Trade financing is provided by vendors
and suppliers who sell their products to the company at short-term, unsecured
credit terms, usually 30 days. Equity and debt financing are usually used for
longer-term investment projects such as investments in a new factory or a new
foreign market. Customer provided financing exists when a customer pays for
services before they are delivered, e.g. subscriptions and insurance.
Trading:
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Answer:
Convertible Bond:
A convertible bond is a bond which can be converted into a company's common
stock. Convertible bonds can provide a substantial additional profit opportunity
for investors. Use these resources to get more information on convertible bonds.
Stock:
In the United Kingdom, South Africa and Australia, the term share is used the
same way, but stocks there refer to either a completely different financial
instrument, the bond, or more widely to all kinds of marketable securities.
Common Stock:
Common stock typically has voting rights in corporate decision matters, though
perhaps different rights from preferred stock. In order of priority in a liquidation of
a corporation, the owners of common stock are near the last. Dividends paid to
the stockholders must be paid to preferred shares before being paid to common
stock shareholders.
Convertible Bond:
A convertible bond is a type of bond that can be converted into shares of stock
in the issuing company, usually at some pre-announced ratio. Although it typically
has a low coupon rate, the holder is compensated with the ability to convert the
bond to common stock, usually at a substantial premium to the stock's market
value.
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securities---generally with high yields---that are mandatory convertible upon
maturity into a variable number of common shares based on the stock price at
maturity.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange for
the benefit of reduced interest payments, the value of shareholder's equity is
reduced due to the dilution expected when bondholders convert their bonds into
new shares.
A simple method for calculating the value of a convertible involves calculating the
present value of future interest and principal payments at the cost of debt and
adds the present value of the warrant. However, this method ignores certain
market realities including stochastic interest rates and credit spreads, and does
not take into account popular convertible features such as issuer calls, investor
puts, and conversion rate resets. The most popular models for valuing
convertibles with these features are finite difference models such as binomial and
trinomial trees.
Why Convertibles?
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The Convertible Bond: A New Solution
Convertible bonds give their holders an option to exchange each bond for a pre-
specified number of shares of common stock of the company under certain
conditions. The pre-specified number of shares for each bond is called
convertible ratio.
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