INSTRUCTIONS: Answer any four (4) questions.

Write your answers on the answer sheets

provided.
Question 1
Smith is considering two investments. He can either purchase shares in NGL or bonds from NPP.
NGL shares cost $95 each and paid $8 in dividends per share at the end of the last year. NGL is
expected to keep dividend payments at $8 per year for the foreseeable future. NPP bonds also
cost $95 but they have a face value of $100, a coupon rate of 10% and a time to maturity of 5
years.
a) What would be Smiths annual rate of return if he invests in NPP bonds?
(10 marks)
b) What would be Smiths annual rate of return if he invests in NGL shares for 5 years,
selling each share for $140 at the end of the fifth year? (Hint: the rate of return is greater
than the rate calculated in part a)
(10
marks)
c) Briefly discuss two differences between stocks and bonds.
(5 marks)

Question 1 ANSWER
a)
Using a Financial Calculator
Face Value = $100
Price = $95
Coupon Payments = $10 (10% of Face Value)
Time to maturity = 5 years
Therefore, Smiths rate of return = 11.37%

Using Financial Tables

PVIFA
PVIF
( 11 , 5 $ 100) $ 95
( 11 , 5 $ 10)+

( 3.696 $ 10 ) +( 0.593 $ 100)

Final Examinations

36.96+59.3=$ 96.26
Therefore , Smit h' s rate of return 11
10 marks
b)
Using a Financial Calculator
FV = $140
Price = $95
PMT = $8
N = 5 years
Therefore, Smiths rate of return = 15.39%

Using Financial Tables

PVIFA
PVIF
( 15 , 5 $ 140) $ 95
( 15 , 5 $ 8)+

( 3.352 $ 8 ) +(0.497 $ 140)

26.82+69.58=$ 96.4
'

Therefore , Smit h s rate of return 15

10 marks

c)
1. Holders of stock have ownership rights, holders of bonds do not
2. Cash payments to stockholders (dividends) can fluctuate over time based on the
performance of the company while coupon payments to bondholders are fixed by the
contractual agreement

Final Examinations

5 marks (2.5 per point)

Question 2
Mike is searching for a stock to include in his current portfolio. He is interested in Apple Inc.; he
has been impressed with the companys computer products and believes Apple is an innovative
market player. However, Mike realizes that any time you consider a so-called high-tech stock,
risk is a major concern. The rule he follows is to include only securities with a coefficient of
variation of returns below 0.9.
Mike has obtained the following information for the period 2006 through 2009. Apple stock,
being growth oriented, did not pay any dividends during these four years.
Stock Price
Year
2006
2007
2008
2009

Beginning
$14.36
$21.55
$64.78
$72.38

End
$21.55
$64.78
$72.38
$91.80

a) Calculate the rate of return for each year, 2006 through 2009 for Apple stock.
(4 marks)
b) Assume that each years return is equally probable and calculate the average return over
this time period.
(4 marks)
c) Calculate the standard deviation of returns, over the four year period.
(10 marks)
d) Based on b and c determine the coefficient of variation of returns for the security.
(2 marks)
e) Briefly discuss the difference between diversifiable and non-diversifiable risk.
(5 marks)
Question 2 ANSWER
a)
Year
2006

Calculations
21.5514.36
100
14.36

Rate of Return
50.07%

2007

64.7821.55
100
21.55

200.6%

2008

72.3864.78
100
64.78

11.73%

Final Examinations

91.8072.38
100
72.38

2009

26.83%

4 marks

b)
Average return =

50.07+ 200.6+11.73+26.83
=72.31
4

4 marks

c)

(r t r p )2
r=
n1
t=1
n

[ (50.0772.31 ) + ( 200.672.31 ) + ( 11.7372.31 ) + ( 26.8372.31 ) ]

r=
41

[ (22.24 ) + (128.29 ) + (60.58 ) + (45.48 ) ]

r=
3
r=

[494.6176+16,458.3241+3,669.9364+2,068.4304 ]
3

r=

22,691.3085
3

r = 7,563.7695
standard deviation of returns=86.97

Final Examinations

10 marks

d)
Coefficient of Variation=

standard deviation 86.97

=
=1.2
average return
72.31

2 marks

e)
Diversifiable risk represents variations in an assets rate of return brought on by factors unique to
a particular industry or the particular asset in question. Investors can protect themselves from
diversifiable risk by investing in a portfolio or collection of assets whose expected rates of return
are inversely correlated. Non-diversifiable risk on the other hand represents variations in an
assets rate of return caused by broad-based factors which affect the rates of returns of all other
assets in the same way (for example a nationwide earthquake). The impacts of non-diversifiable
risk cannot be reduced by diversification.
5 marks

Question 3
Jamie Peters invested $300,000 to set up the following portfolio one year ago:
Asset

Cost

A
B
C
D

$60,000
$105,000
$100,000
$35,000

Beta at
purchase
0.80
0.95
2.50
1.25

Yearly
income
$5,600
$3,400
$975

Value
today
$60,000
$150,000
$90,500
$40,500

a. Calculate the portfolio beta on the basis of the original cost figures.
(5 marks)
b. Calculate the percentage return of the portfolio on the basis of original cost, using
income and capital gains during the year.
(5 marks)
c. At the time Jamie made his investments, investors were estimating that the market
return for the coming year would be 10%. The estimate of the risk-free rate of return
averaged 4% for the coming year. Calculate an expected rate of return for each stock
on the basis of its beta and the expectations of market and risk-free returns.
(10 marks)
d. Briefly discuss the significance of Beta values.
(5 marks)

Final Examinations

Question 3 ANSWER
a)
Total cost of portfolio = $60,000 + $105,000 + $100,000 + $35,000 = $300,000
Asset

Beta at
purchase

Weight in
portfolio

0.80

60,000
=0.20
300,000

0.95

105,000
0.95 0.35=0.3325
=0.35
300,000

2.50

100,000
2.5 0.33=0.83
=0.33
300,000

1.25

35,000
1.25 0.117=0.1458
=0.117
300,000

Portfolio Beta

Weight
multiplied by
beta
0.8 0.2=0.16

1.47

5 marks

b)
Asset
A

Weight in
portfolio
0.2

Cost
$60,000

Yearly
income
$5,600

Value
today
$60,000

Rate of Return

( 60,00060,000 ) +5,600
=
60,000
0.093
150,000105,000
=0.461
+3,400
105,000

0.35

$105,000

$3,400

$150,000

0.33

$100,000

$90,500

90,500100,000
=0.095
100,000

0.117

$35,000

$975

$40,500

(40,50035,000)+ 975
=0.185
35,000

Percentage return of portfolio =

( 0.093 0.2 ) + ( 0.461 0.35 ) + (0.095 0.33 )+ ( 0.185 0.117 )=0.0186+0.161350.03135+0.021645=0.17024

Final Examinations

OR

( 341,000300,000 ) +9,975
300,000
50,975
=0.169916.99
300,000
5 marks

c)

Asset

CAPM Calculations
r j =4 +[0.8 ( 10 4 ) ]

Expected return
8.8%

r j =4 +[0.95 ( 10 4 ) ]

9.7%

r j =4 +[2.5 (10 4 ) ]

19%

r j =4 +[1.25 (10 4 ) ]

11.5%

10 marks

d)
Beta values measure the responsiveness of the return of an asset to changes in the market
rate of return. Beta values are therefore measures of non-diversifiable risk. A beta value of
1 indicates that an assets return moves in tandem with the average market rate.
Consequently, a 3% increase in the market rate leads to a 2% increase in the assets return.
An asset with a beta value of two will experience a 2% increase or decrease in its return of
the market rate increases or decreases by 1%. Therefore, the higher the beta value of an
asset, the greater its responsiveness to changes in the average market rate and the greater
its degree of non-diversifiable risk. The greater the risk of an asset the higher its rate of
return.
5 marks

Question 4
Colnet Ltd, an online marketing firm, has invited you to invest in their company by purchasing
shares of common or preferred stock.
Final Examinations

a) Briefly describe two advantages and two disadvantages of investing in common stock as
opposed to preferred stock.
(8 marks)
b) If the company paid dividends per common share of $25 at the end of the last year and
dividend payments are forecasted to increase at a rate of 5% per year, what is the
maximum amount you would be willing to pay for a share of common stock if you would
like to earn an annual rate of return of no less than 15%?
(10 marks)
c) If the companys preferred shares have a par value of $120 each and pays dividends at a
rate of 10%, what is the maximum amount you would be willing to pay for a share of
preferred stock in order to at least earn an annual rate of return of 15%?
(7 marks)

Question 4 ANSWER
a)
Advantages

Common stockholders have voting rights while preferred stockholders usually do

not
Common stockholders can benefit substantially as residual claimants through large
dividend payments (or via the distribution of the assets of a liquidated company) if a
substantial amount of net cash flow (or assets) remains after the firm pays its
creditors and preferred stockholders.

Disadvantages

Firms may choose to reinvest significant amounts of profits, forgoing dividend

payments to common stockholders in the short term. This may persuade a common
stockholder looking for a positive short term return to sell his stock even if he may
want to remain a part owner of the company.
Common stockholders as residual claimants may not receive dividend payments or
assets at the liquidation of a firm if insufficient assets remain after creditors and
preferred stockholders are given their share first.

8 marks (2 marks each)

b)
P 0=

0 ( 1+ g)
r sg

Final Examinations

P 0=

25 (1+ 0.05)
0.150.05

P 0=

26.25
0.1 0

P0=$ 262.50
10 marks

c)
P 0=
r
P 0=

$ 120 10
0.15

P 0=

12
0.15

P0=$ 80
7 marks

Question 5
Hook industries is considering the replacement of one of its old drill presses. Three alternative
replacement presses are under consideration. The relevant cash flows associated with each are
shown in the following table. The firms cost of capital is 15%.
Initial investment
Year
1
2
3
4
5
6

Press A
$85,000
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000

Press B
$60,000
Net cash inflows
$12,000
$14,000
$16,000
$18,000
$20,000
$25,000

Press C
$130,000
$50,000
$30,000
$20,000
$20,000
$20,000
$30,000

Final Examinations

7
8

$18,000
$18,000

$40,000
$50,000

a) Calculate the Net Present Value (NPV) of each press.

b) Evaluate the acceptability of each press using NPV.
c) Briefly explain what is meant by the term Internal Rate of Return.

(9 marks)
(9 marks)
(7 marks)

Question 5 ANSWER
a)
Press A
PV =CF PVIFA 15 , 8
PV =$ 18,000 4.487
PV =$ 80,766

NPV =$ 80,766$ 85,000

NPV =$ 4,234

(-$4,228.21 using a financial calculator)

Press B
Year
1
2
3
4
5
6

Cash Flow
$12,000
$14,000
$16,000
$18,000
$20,000
$25,000
Total

PVIF15 , 6

PV

0.870
0.756
0.658
0.572
0.497
0.432

$10,440
$10,584
$10,528
$10,296
$9,940
$10,800
$62,588

NPV =$ 62 , 588$ 60 , 000

Final Examinations

NPV =$ 2,588

($2,584.34 using a financial calculator)

Press C
Year

Cash Flow

1
2
3
4
5
6
7
8

$50,000
$30,000
$20,000
$20,000
$20,000
$30,000
$40,000
$50,000
Total

PVIF15 , 6

PV

0.870
0.756
0.658
0.572
0.497
0.432
0.376
0.327

$43,500
$22,680
$13,160
$11,440
$9,940
$12,960
$15,040
$16,350
$145,070

NPV =$ 145 , 070$ 13 0 , 000

NPV =$ 15 , 070 ($15,043.89 using a financial calculator)

12 marks (4 marks each)

b)

Press A should be rejected since it has a negative NPV.

Both Press B and C have positive NPVs and should be considered
Press C is preferred to Press B since it has a larger NPV indicating that it will earn
the firm a greater amount of net cash flow than Press B.

6 marks (2 marks each)

c)
The internal rate of return is the forecasted annual rate of return of a project. It is
calculated by equating the present value of all future net cash flows of a project with the
initial price of the investment and solving for the interest or discount rate.
7 marks

Question 6

Final Examinations

Sauce Doubles Inc. is selling bonds to raise capital to expand its operations to Latin America.
Each bond has a face value of $10,000, a coupon rate of 12% and a time to maturity of 5 years.
a) What is the maximum amount you would be willing to pay for a bond if your next best
investment opportunity earns you an annual rate of return of 7%?
(7 marks)
b) If you deposit your earnings from the bonds as they are received (at the end of each year)
into an account paying annually compounded interest of 5%, how much money would
you have in your bank account at the end of the five years assuming you purchased one
hundred bonds?
(7 marks)
c) Assuming that the bonds were sold at face value, what would be your rate of return if you
purchased one hundred bonds and then sold them for $12,000 each after one year?
(5 marks)
d) Briefly explain why the price of a bond may differ from its face value.
(6 marks)
Question 6 ANSWER
a)
PVIFA
( 7 , 5 years 1,200)+( PVIF 7 ,5 years 10,000)
PV =
PV =( 4.1 1,200 ) +(0.713 10,000)
PV =4,920+7,130

PV =$ 12,050
7 marks

b)
FV =[ ( FVIFA 5 ,5 years 1,200 ) +10,000 ] 100
FV =[ ( 5.526 1,200 ) +10,000 ] 100
FV =(6,631.2+10,000) 100

FV =16,631.2 100

Final Examinations

FV =$ 1,663,120
7 marks

c)
r=

C+ P t+1 P t
Pt

r=

( 12,000+1,200 )10,000
10,000

r=32
5 marks

d)
Changes in market interest rates would cause the price of a bond to change also. For example, if
market interest rates rise from 10% to 12%, then a coupon bond with a coupon rate of 10%
would have to sell for a price that is lower than its face value to increase its yield and attract
buyers. If the price of the coupon bond remains at face value, investors would invest elsewhere
since the bonds yield would be 10% while investors can earn 12% elsewhere. The decrease in
the price of the bonds will aligned its yield with the market yield thus increasing its
attractiveness to investors.
6 marks

END OF EXAMINATION

Formula Sheet
Basic Time Value Calculations
One off cash flows
n
1. FV =PV (1+i)

Final Examinations

2.
Where:

PV =

FV
(1+i )n

FV

= the future value of cash flow

PV

= the present value of cash flow

= the rate of interest / the rate of required return

= the time period in years of the investment (the time (in years) to

maturity
(1+i)n

of a debt instrument)
= the Future Value Interest Factor (FVIFi,n)

1
(1+i)n

= the Present Value Interest Factor (PVIFi,n)

Annuities

3. FV n=CF FVIFA i , n
4. PV n=CF PVIFA i , n
Where:
FV n

= the future value of an annuity

PV n

= the present value of an annuity

= the rate of interest / the rate of required return

= the time period in years of the investment (the time (in years) to

maturity
of a debt instrument)
FVIFA i ,n = the future value interest factor for annuities given

and

n
PVIFA i ,n

= the present value interest factor for annuities given

and n
CF = the annuitys annual cash flow

Final Examinations

Perpetuities
CF
PV =
i
Where:
PV

= the present value of a perpetuity

CF

= the perpetuitys annual cash flow

= the rate of interest / the rate of required return

Bonds
PV =

5.

CP
CP
CP
FV
+
+ +
+
n
n
1+i (1+i)2
(1+i) (1+i)

Where:
FV

= the face value of the bond

PV

= the present value of the bond

CP

= the bonds annual coupon payment

= the market rate of interest or the rate of required return / the

bonds yield to maturity

n = the bonds time to maturity

6.

Current Yield=

Annual Interest Payments

100
Initial Investment (the price of the bond)

Stocks

7.

P o=

1
2

+
+
+

(1+ r s ) (1+r s)2

(1+r s )

Final Examinations

P 0=

8.

0 ( 1+ g)

= 1
r sg
r s g

Where:
P0=toda y ' s value of the stock ( its price )
t =dividend payments year' t '
r s =therequired return on theinvestment
g

= the annual growth rate of dividends

Risk and return

r=

9.

C+ P t+1 P t
Pt

Where:
r=return on holding a fin ancial asset time t t+1
Pt =price of the asset at time t
Pt +1= price of asset at timet +1
C=Interest payments madeby the asset

10.
Where:

r j Pj
j=1

r j =the return of the jth outcome

P j =the probability of the jth outcome
n=the number of possible outcomesscenarios

11.

r=

j=1

( r jr )2 Pr j

Final Examinations

Where:
r =the standard deviation of returns for a particular investment
r =the expected rate of return of the investment
Pr j=the probability associated with the rate of return for outcome j

CV =

12.
Where:

CV =the coefficient of variation of an investment

'

=the standard deviationof an investment s returns

r =the expected return of an investment

r =

13.

(r tr p)2
n1
t =1
n

Where:
r =the standard deviation of the portfolio
p

r t =the expected return on the portfolio time t

r p=the portfoli o' s expected an nual rate of return
n=thenumber of yearsof the investment

14.

r j =RF +[ b j ( r m RF ) ]

Where:
r j =the required return on asset j
RF =the risk free rate return usually measured by the return on government bonds

Final Examinations

'

b j=asset j s betacoefficient
r m=themarket rate of retu rn

Capital Budgeting

15.

16.

NPV =

NCF 1 NCF 2
NCF n
+
+ +
IV 0
2
n
1+ x ( 1+ x )
( 1+ x )

IRR
1+

( n)
NCF 1
NCF 2
NCF n
+
++
2

1+ IRR ( 1+IRR )
IV 0=
Where :
NPV =Net Present Value

NCF n=Net Cash Flow year n

n=thelenght years of the project
x=the fir m' s cost of capital
IV 0=theinitial cost of the investment
IRR=the internal rate of return

Final Examinations