Professional Documents
Culture Documents
Data
Capital $ 100,000.00 1
Interest Rate 9% PV 91743.11927
n Years 6 PV Annuity
Growth 2.5% PV Perpetuity
PV Annuity Growing
PV Perpetuity Growing
Er 10%
Risk Aversion 2.4 Free Cash Flow
Variance 9% Dividend Growth Model
Dividend Payments Stock Price
Total Payouts Equity Value
Free Cash Flows Enterprise Value
Holding Period Return
Effective Annual Rate
Annualized Percentage Rate
Sharpe Ratio Reward to Volatility Ratio
Utility
Expected Return
1. Solve NEW exercises beside the existing tutorials for every Chapter
2. Write all Formulas in a Word + beside every exercise
2 3 4 5 6 Other
84167.99933 77218.34801 70842.52111 64993.13863 59626.73269
448591.8590231
$ 1,111,111.11
474634.9315735
1538461.538462
erprise Value
(ending price - beginning price + divident or i
a)
FV 9284.86191111
b)
FV 863965.411242
c)
PV 546.17
r (1) 12%
r(2) 2%
0 1 2 3
CF -20000 1000 3000
PV -20000 892.86 2391.58 0.00
a)
NPV -10276.096493 No, we should not take the opportunity
b)
0 1 2 3
CF -20000 1000 3000
PV -20000 980.39215686 2883.506344 0
NPV 270.86449808 Yes, we should take the opportunity
Bond 200
r 12%
a)
Value of P (after) 1666.66666667
b)
Value of P (before) 1866.67 Perpetuity V + Perpetuity V*r
The Perpetuity
CF year 6 27697936
Discount rate 7%
Growth 3%
Value year 5 692448400
Value year 0 493706139
A)
r 13%
1 2 3
Time 0 -2500 -2000 -1000
Cash flow 5000 -2193.2 -1539.3 -675.2
select an interest rate by yourself to begin with, then calculate the PV based on it. Afterward we can use "goal se
PV 5000
NPV 5000 2. Use Goal Seek to find out IRR - 1) Set cell: curren
IRR 13.99% IRR - invest only when IRR is higher than 14% becau
B)
r 10%
0 1 2 3
Cash flow 5000 -2500 -2000 -1000
NPV 0.0
C)
r 20%
Time 0 1 2 3
Cash flow 5000 -2500 -2000 -1000
PV 5000 -2083.333333 -1388.88889 -578.703704
NPV rule and IRR rule are consistent, under IRR rule, we rejected projects with IRR under 14% which showed tha
DeepW fishing CF 0 1 2 3
CF -600000 270000 350000 300000
PV -600000 217224.78493 226547.4968 156227.7183
NPV 0
IRR 24%
NewMarine CF 0 1 2 3
CF -1800000 1000000 700000 900000
PV -1800000 823294.36321 474469.5259 502236.1109
NPV 0
IRR 21%
--------------------------------------------------------------------------------------
Annual Return 15%
DeepW fishing CF 0 1 2 3
CF -600000 270000 350000 300000
PV -600000 234782.6087 264650.2836 197254.8697
NPV 0
NewMarine CF 0 1 2 3
CF -1800000 1000000 700000 900000
PV -1800000 869565.21739 529300.5671 591764.6092
NPV 0
We will go for the NSM as the NPV is much higher than for the DWF. The IRR is not consistent with NPV
If all IRR are positive - we have only 1 irr, but here we have changes 4 times so we have 4 IRRs
0 1 2 3
Cash Flow -504 2862 -6070 5700
PV -504.0 2290.4 -3887.5 2921.5
NPV 0.0
Average of these 4 years, but it changes 4 times
IRR 25% IRR, NPV, r - are connected
IRR NPV
5.0% -5.485
10% -2.243
15.0% -0.760 Chart IRR
20% -0.173 1.000
25.0% 0.000
0.000
30% 0.014 0.0% 20.0% 40.0% 60.0% 80.0%
35.0% -0.006 -1.000
40% -0.010
-2.000
45.0% 0.012
50% 0.049 -3.000
-4.000
-5.000
-1.000
-2.000
-3.000
55.0% 0.080
-4.000
60% 0.082
65.0% 0.032 -5.000
70% -0.090
-6.000
75.0% -0.300
80% -0.610
85.0% -1.031 X axis - IRR
90% -1.567 Y axis - NPV
95.0% -2.223
100% -3.000
4 5 6 7 8 9 10
20000
0 0 0 0 0 0 6439.4647
4 5 6 7 8 9 10
20000
0 0 0 0 0 0 16406.966
ke the opportunity
r year 1 ( 7000000)
wing Annuity Year 1-5 (60128108)
wing perpetuity FOR YEAR 6 (but first calculate Value for year 5)
e of Perpetuity
alue Perpetuity
4
-1000
-592.3
to find out IRR - 1) Set cell: current NPV (so find it first) 2) Value: 0, 3) By changing cell: IRR
when IRR is higher than 14% because NPV should not be lower than 0
4
-1000
-683.013455
4
-1000
-482.253086
IRR under 14% which showed that NPV is negative. When IRR is above 14%, the NPV is positive
CF/(1+irr)^t
not consistent with NPV
4
-2000
-820.3
hanges 4 times
Chart IRR
Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi M
for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9.14 million this year and b
Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are
Mochi Munch is 36%, and its gross profit margin averages 24% for all other products. The company’s marginal
Find the Unleavered Income
Question 1: What are the incremental earnings associated with the advertising campaign?
0 1 2 3
Cost $ (3.76)
MMM $ 9.14 $ 7.14
Other $ 3.55 $ 3.55
Marg Tax 38% 38%
Ch. 8, problem
Castle View Games would like to invest in a division to develop software for video games. To evaluate this decis
financial officer has developed the following estimates (in millions of dollars):
Question 1: Assuming that Castle View currently does not have any working capital invested in this divisi
years of this investment.
0 1 2 3
Cash 7 12 16
Recievable 19 25 26
Inventory 6 7 11
Payable 16 21 23
Cash Flows 16 23 30
Page 280
DELTA NET WORKING CAPITAL??
Ch. 8, problem
Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are d
years (in millions of dollars):
Question 1: What are the incremental earnings for this project for years 1 and 2?
Year 1 Year 2
Revenue 106.5 159.9
Cost of sold
goods,
expenses 47.7 59.5
Depreciation 25.9 35.5
Net Capital
Increase 3.1 7.6
Capital
Expenditure 29.1 43.8
Marginal Tax 40% 40%
Ch. 8, problem 1
Bay Properties is considering starting a commercial real estate division. It has prepared the following four-yea
division:
Year 1 2 3
Free Cash flow -159,000 14,000 98,000
Question 1: Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this
What is the value today of this division?
v 0 1 2 3
Free Cash
Flow -159000 14000 98000
Discout!! -139473.684211 10772.5454 66147.20859
Chapter 9
Ch. 9, problem 1
DFB, Inc., expects earnings at the end of this year of $4.01 per share, and it plans to pay a $2.09 dividend at tha
expected return of 15.1% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, an
shares.
Question 1: What growth rate of earnings would you forecast for DFB?
Question 3: Suppose DFB instead paid a dividend of $3.09 per share at the end of this year and retained o
what stock price would you estimate now? Should DFB raise its dividend?
Even if you think it's silly, just write that increasing the dividend will cause a decrease in share price!
Ch. 9, problem 1
Proctor and Gamble paid an annual dividend of $1.72 in 2009. You expect P&G to increase its dividends by 8%
appropriate equity cost of capital for Proctor and Gamble is 8% per year.
Question 1: Use the dividend-discount model to estimate its value per share at the end of 2009
2009 1
Dividend per share $1.72 $1.86
Dividend growth (1-5) 8.00%
Dividend growth (6-∞) 3.00% $1.86
Cost of capital 8.00% 1.72
Share price (PV) $ 44.03
Ch. 9, problem 1
Suppose Amazon.com Inc. pays no dividends but spent $1.88 billion on share repurchases last year. If Amazon’s
6.4% per year, estimate Amazon’s market capitalization.
Question 1: If Amazon has 432 million shares outstanding, what stock price does this correspond to?
Information:
Heavy Metal Corporation is expected to generate the following free cash flows over the next five years:
Year 1 2
Free Cash flow ($ millions) 51.30 69.70
PV 44.842657343 53.257494254
After then, the free cash flows are expected to grow at the industry average of 4.3% per year. Using the discount
PV 6 years on 854.020792079
Discounted 435.851276146
EV = 443.76 This is the present value of all of the future cash flows
PV 672.636392744
Question 2: If Heavy Metal has no excess cash, debt of $280 million, and 35 million shares outstanding, es
Debt $ 280.00
Shares outstanding 35.00
Mkt Cap $ 392.64
Share Price $ 11.22 = 672.64 - 280.00
Ch. 9, problem 2
You notice that PepsiCo (PEP) has a stock price of $72.62 and EPS of $3.93. Its competitor, the Coca-Cola Com
Question 1: Estimate the value of a share of Coca-Cola stock using only this data.
PepsiCo Coca-Cola
Stock price $72.62 $39.36
EPS $3.93 $2.13
P/E 18.4783715013
$39.36
Better to use earnings before interest and tax. If you just use earnings before tax, interest can skew the
P/E is adequate if valuing banks or financial institutions because the interest rate is similar.
Ch. 9, problem 2
Suppose that in January 2006, Kenneth Cole Productions had sales of $531 million, EBITDA of $51.3 million, e
Question 1: Using the average enterprise value to sales multiple in Table 9.1, estimate KCP’s share price.
Question 4: What range of share prices do you estimate from the highest and lowest enterprise value to E
see above
Ch. 9, problem 2
Consider the following data for the airline industry for December 2015 (EV = enterprise value, Book = tangible
Accounting is different in different countries, so the P/Book ratio might look different for the same company in
Operating in the same industry does not mean you operate in the same sub industry. Some companies
hange as a result of the investment decision
eparate from any financing decisions
cent.
Chapter 8
Ch. 8, problem 2
atest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $3.76 million on TV, radio, and print advertising this year
Munch by $9.14 million this year and by $7.14 million next year. In addition, the company expects that new consumers who try the
. As a result, sales of other products are expected to rise by $3.55 million each year. Kokomochi’s gross profit margin for the Mini
ther products. The company’s marginal corporate tax rate is 38% both this year and next year.
dvertising campaign?
4 5.555555555
5.5555555556
237
Ch. 8, problem 7
for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation. Its chief
lars):
working capital invested in this division, calculate the cash flows associated with changes in working capital for the first five
4 5
15 14
21 23
14 15
25 31
25 21
Ch. 8, problem 9
es. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two
ars 1 and 2?
Revenues minus
expenses and
FIND EBIT depreciation.
FCF add depreciation minus capital expenditures minus increase in net working capital.
two years?
Ch. 8, problem 19
It has prepared the following four-year forecast of free cash flows for this
4
221,000
forever. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash flows after year 4?
d it plans to pay a $2.09 dividend at that time. DFB will retain $1.92 per share of its earnings to reinvest in new projects with an
dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding
B?
3.464339152119700%
d you estimate for DFB stock today?
$ 37.52
at the end of this year and retained only $0.92 per share in earnings. If DFB maintains this higher payout rate in the future,
dend?
$ 33.10 No??
ect P&G to increase its dividends by 8% per year for the next five years (through 2014), and thereafter by 3% per year. The
r.
Ch. 9, problem 16
hare repurchases last year. If Amazon’s equity cost of capital is 8.1%, and if the amount spent on repurchases is expected to grow by
PV = $ 110.59 bn
P0 = $ 255.99
Ch. 9, problem 19
3 4 5 6
79.50 74.30 82.70 86.2561
53.099331716 43.3795173783 42.2061159068
ge of 4.3% per year. Using the discounted free cash flow model and a weighted average cost of capital of 14.4%.
100.00
90.00
80.00
70.00
60.00
50.00 FCF
ure cash flows
PV
40.00
30.00
20.00
10.00
0.00
1 2 3 4 5 6
Ch. 9, problem 24
3.93. Its competitor, the Coca-Cola Company (KO), has EPS of $2.13.
Ch. 9, problem 26
31 million, EBITDA of $51.3 million, excess cash of $107 million, $3.3 million of debt, and 23 million shares outstanding
Ch. 9, problem 28
EV = enterprise value, Book = tangible book value). Discuss the challenges of using multiples to value an airline.
the perpetuity
14.4%.
Enterprise Value
FCF
PV
ares outstanding
debt - cash/investments
n airline.
Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi
print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $
company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s oth
$3.55 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 36%, and its gross prof
corporate tax rate is 38% both this year and next year.
Find the Unleavered Income
Question 1: What are the incremental earnings associated with the advertising campaign?
0 1 2
Incremental Earnings ($000)
Sales MMM $ 9.140 $ 7.140
Gross Profit Margin(1) 36% 36%
Sales Other $ 3.550 $ 3.550
Gross Profit Margin(2) 24% 24%
Gross Profit $ 4.142 $ 3.422
Ch. 8, problem 7
Castle View Games would like to invest in a division to develop software for video games. To evaluate this deci
operation. Its chief financial officer has developed the following estimates (in millions of dollars):
Question 1: Assuming that Castle View currently does not have any working capital invested in this divis
capital for the first five years of this investment.
Ch. 8, problem 9
Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are
flows for the first two years (in millions of dollars):
Information Year 1
Revenues 106.50
COSG and operating expenses 47.70
Depreciation 25.90
Increase in net working capital 3.10
Capital expenditures 29.10
Marginal corporate tax rate 40%
Question 1: What are the incremental earnings for this project for years 1 and 2?
* Incremental earnings > inc. all incremental revenues and costs associated with the project, incl. project extern
Question 2: What are the free cash flows for this project for the first two years?
Ch. 8, problem 19
Bay Properties is considering starting a commercial real estate division. It has prepared the following four-ye
division:
Year 1 2
Free Cash flow -159,000 14,000
Question 1: Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for thi
flows after year 4? What is the value today of this division?
Year 1 2
Free Cash flow -159,000 14,000
Continuation Value
Year 1 2
Free Cash flow -159,000 14,000
Continuation Value
Total CF to be discounted -159,000 14,000
Present Value -139474 10773
Ch. 9, problem 10
DFB, Inc., expects earnings at the end of this year of $4.01 per share, and it plans to pay a $2.09 dividend at th
new projects with an expected return of 15.1% per year. Suppose DFB will maintain the same dividend payout
will not change its number of outstanding shares.
Question 1: What growth rate of earnings would you forecast for DFB?
Question 2: If DFB’s equity cost of capital is 12.8%, what price would you estimate for DFB stock today?
Question 3: Suppose DFB instead paid a dividend of $3.09 per share at the end of this year and retained
payout rate in the future, what stock price would you estimate now? Should DFB raise its dividend?
No, the DFB should not raise it’s dividend because the Stock price goes down as dividend raises up
Ch. 9, problem 12
Proctor and Gamble paid an annual dividend of $1.72 in 2009. You expect P&G to increase its dividends by 8
per year. The appropriate equity cost of capital for Proctor and Gamble is 8% per year.
Question 1: Use the dividend-discount model to estimate its value per share at the end of 2009
Suppose Amazon.com Inc. pays no dividends but spent $1.88 billion on share repurchases last year. If Amazon’
is expected to grow by 6.4% per year, estimate Amazon’s market capitalization.
Question 1: If Amazon has 432 million shares outstanding, what stock price does this correspond to?
0 1
CF (last year) 1.88 2.00 =C203*(1+C199)^D202
Growing Perpetuity 117.67 =D203/(C198-C199)
Ch. 9, problem 19
Heavy Metal Corporation is expected to generate the following free cash flows over the next five years:
Year 1
Free Cash flow ($ millions) 51.30
After then, the free cash flows are expected to grow at the industry average of 4.3% per year. Using the discoun
14.4%.
Year 1
Free Cash flow ($ millions) 51.30
Growing perpetuity
PV (discount ) 44.8426573
Question 2: If Heavy Metal has no excess cash, debt of $280 million, and 35 million shares outstanding, e
Shares 35
CF 672.6
Debt 280
Ch. 9, problem 24
You notice that PepsiCo (PEP) has a stock price of $72.62 and EPS (earnings per share) of $3.93. Its competit
Question 1: Estimate the value of a share of Coca-Cola stock using only this data.
PepsiCO (PEP) Coca-Cola (KO)
Stock price $ 72.62 $ 39.36
EPS (earnings per share) $ 3.93 $ 2.13
Ch. 9, problem 26
Suppose that in January 2006, Kenneth Cole Productions had sales of $531 million, EBITDA of $51.3 million,
outstanding
Sales $ 531.00
EBITDA 51.3
Excess cash $ 107.00
Debt $ 3.3
Shares outs 23
Question 1: Using the average enterprise value to sales multiple in Table 9.1, estimate KCP’s share price
Question 2: What range of share prices do you estimate based on the highest and lowest enterprise value
Question 3: Using the average enterprise value to EBITDA multiple in Table 9.1, estimate KCP’s share p
Question 4: What range of share prices do you estimate from the highest and lowest enterprise value to
Ch. 9, problem 28
Consider the following data for the airline industry for December 2015 (EV = enterprise value, Book = tangib
airline.
Accounting is different in different countries, so the P/Book ratio might look different for the same co
Operating in the same industry does not mean you operate in the same sub industry. Some companie
Chapter 8
Ch. 8, problem 2
ssert product, the Mini Mochi Munch. Kokomochi plans to spend $3.76 million on TV, radio, and
of the Mini Mochi Munch by $9.14 million this year and by $7.14 million next year. In addition, the
re likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by
nch is 36%, and its gross profit margin averages 24% for all other products. The company’s marginal
ng campaign?
3 4
Revenue*Gross Margin
Gross Profit - Operating Expenses (Ads campaign) > (get EBIT this way)
EBIT*Tax rate
Unlevered income = EBIT-Tax rate
Ch. 8, problem 7
o games. To evaluate this decision, the firm first attempts to project the working capital needs for this
llions of dollars):
capital invested in this division, calculate the cash flows associated with changes in working
ough long-term cash flows are difficult to estimate, management has projected the following cash
Year 2 Unlevered income - means, cash available to capital investors without taking i
159.90 - the money we get (as a firm) before paying any outsta
59.50 Earning = PROFIT - EXPENSES
35.50
7.60
43.80
40%
nd 2?
the project, incl. project externalities and opportunity costs but excluding sunk costs and interest expenses |
,= Revenue - Costs
,=EBIT * Tax rate
,= EBIT - Tax rate
ars?
Corporate tax
Ch. 8, problem 19
prepared the following four-year forecast of free cash flows for this
3 4 5 6>
98,000 221,000 227630 0
r. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash
3 4 5
98,000 221,000 227630 = 221.000*(1+3%)
2069364 =227630/(14%-3%)
3 4
98,000 221,000
2069364
98,000 2,290,364
66147 1356079
PV is to be discounted from FCF, but I used 'Total CF to be discounted' because Year 4 the nr. is differen
ns to pay a $2.09 dividend at that time. DFB will retain $1.92 per share of its earnings to reinvest in
ain the same dividend payout rate, retention rate, and return on new investments in the future and
nd of this year and retained only $0.92 per share in earnings. If DFB maintains this higher
DFB raise its dividend?
Div1 = (rE - g) * P0
wn as dividend raises up
Ch. 9, problem 12
to increase its dividends by 8% per year for the next five years (through 2014), and thereafter by 3%
er year.
Ch. 9, problem 16
urchases last year. If Amazon’s equity cost of capital is 8.1%, and if the amount spent on repurchases
* we use the Growing perpetuity because the growth is fixed at 6.4% (it just continues to grow)
** convert millions to bill = 432/100 = 4.32
Growing Perpetuity
Ch. 9, problem 19
2 3 4 5
69.70 79.50 74.30 82.70
3% per year. Using the discounted free cash flow model and a weighted average cost of capital of
2 3 4 5 6
69.70 79.50 74.30 82.70 86.2561 1. Calculate the CF for year 6
854.020792 2. Calculate the growing Perpetuity
53.257494 53.099332 43.379517 42.2061159 435.851276 2. Discount PV = CF/(1+WACC)^time
4. calculate the entreprise value (NPV)
500.00
450.00
million shares outstanding, estimate its share price.
400.00
2. THERE'S DEBT300.00
280, = (CF - DEBT)
3. (CF-DEBT)/ NR250.00
SHARES
200.00
(CF-DEBT)/ NR SHARES
150.00
100.00
50.00
Ch. 9, problem 24 0.00
0 1 2
r share) of $3.93. Its competitor, the Coca-Cola Company (KO), has EPS of $2.13.
data.
Ch. 9, problem 26
on, EBITDA of $51.3 million, excess cash of $107 million, $3.3 million of debt, and 23 million shares
e price from EV
nterprise value, Book = tangible book value). Discuss the challenges of using multiples to value an
s debtors.
money you require to expand your business, meet short-term business responsibilities and cover business expenses.
Delta = change ( + -)
pital investors without taking into account any interest payments due on outstanding capital debt
firm) before paying any outstanding debt
1. Solve NEW exercises beside the existing tutorials for every Chapter
Corporate tax 2. Write all Formulas in a Word + beside every exercise
'Cost capital' and 'r' is the same
C of Cap-cost of keeping the money without using them
500.00
450.00
400.00
350.00
DEBT300.00
280, = (CF - DEBT)
)/ NR SHARES
250.00
200.00
150.00
100.00
50.00
0.00
0 1 2 3 4 5 6 7
ness expenses.
Holding Period Return
Standard Deviation is RISK
Certainty Equivalent Rate
Indifference curve plotting the Expected Return against an investor's utility
Expected Value of the Return on the Portfolio
Standard Deviation of the value of the portfolio
Equation for the proportion of the amount to invest in risky asset, thus also the risk free asset.
Ch. 5, problem
You’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back to 1
Question 1: What are the advantages and disadvantages in using these data to help estimate the expected rate of return
Advantages: we have many data points to create a statistical average and predict the actions of the future. We can measure certa
correspond best with the present year. The larger the sample size the better
Disadvantages: The data that we have proves that some market conditions are only 20/20 in hindsight. Trying to predict the futu
to failure. The future is not DEPENDANT on the past, but follows the past. Er is a calculation of future values, not past values,
doesn't have any bearing on the equation.
Ch. 5, problem
Answers:
A large role, but not the only role. The money market fund I would have good liquidity and not worry about losing access to mo
Bond where I am lilkely to only put 'extra' cash into it. The one year deposit is a good compromise of liquidity and security. If y
year bond, you might be stuck with a great interest rate or with a low interest compared to the market!
A large role, but not the only role. The money market fund I would have good liquidity and not worry about losing access to mo
Bond where I am lilkely to only put 'extra' cash into it. The one year deposit is a good compromise of liquidity and security. If y
year bond, you might be stuck with a great interest rate or with a low interest compared to the market!
Ch. 5, problem
Answers:
Information:
Probability HPR End $ Beg $ Validate
Boom 0.35 44.5% $ 140.00 $ (252.25) $ (1.56)
Normal growth 0.3 14.0% $ 110.00 $ (127.91) $ (1.86)
Recession 0.35 -16.5% $ 80.00 $ (68.67) $ (2.17)
Solutions
Ch. 5, problem
Information:
Nominal HPR 80%
Inflation rate 70%
Probability 100%
a. What is the real HPR on the bond over the year?
Ch. 6, problem
Good state Bad state
End of the year cash flow 200,000 70,000
Probabilities 0.5 0.5
4.a answers
Risk premium 8%
4.b answers
If you purchased the portfolio at that price, the rate of return would be 14%, which is the risk free rate plus your risk premium.
135000
4.c answers
P= $ 114,406.78 In order to get the 12% risk premium, you have to buy the portfolio for less.
4.d answers
higher risk premium = lower price
Ch. 6, problem
Answers:
Information SD Er Er
Utility level U 0.05 0 0.05 0.05
Risk aversion A 3 0.05 0.05375 0.055 2.5
New Risk AversA* 4 0.1 0.065 0.07
0.15 0.08375 0.095 2
Expected Return
1.5
0.25 0.14375 0.175
0.3 0.185 0.23 1
0.35 0.23375 0.295
0.4 0.29 0.37 0.5
0.45 0.35375 0.455
0
0.5 0.425 0.55 0 0.2
0.7 0.785 1.03
1 1.55 2.05
Ch. 6, problem
Answers:
Information
Utility level U 0.05
Risk aversion A 4
Ch. 6, problem
Answers:
Information
rf 8%
σf 0%
(1-y): safe 30%
E(rp) 18%
σp 28%
y: risky 70%
S (expected return) 15.00%
SD 19.60000%
Ch. 6, problem
Answers:
Revelant information from problem 13:
rf = 8%
σf = 0%
E(rp) = 18%
σp = 28%
S= #DIV/0! 5/ 14
Why are the sharpe ratio's the same?? Because both investors invest ON THE CAL. Thus, they both have the same Sharpe ratio
Draw the graph in the exam!!
Always give more information than too little!
Ch. 6, problem
17.a answers:
Revelant information from problem 13 and this question: ErC = ErP*y + rF - rF*y
rf = 8% y = [E(rC) - rF] / [ErP - rF]
E(rp) = 18%
E(rC) = 16%
y= 80.00%
17.b answers:
17.c answers:
Information
σp = 28% How do you get total SD without the rF asset deviation?? Ass
σC = 22.40%
Ch. 6, problem
19.a answers:
Information
Risk aversion A = 3.5
rf 8% y = (Erp - rF) / (A*∂^2p)
σf 0%
(1-y): safe 30%
E(rp) 18%
σp 28%
y: risky 70%
y 0.3644314869
19.b answers:
Ch. 6, problem
CAL: Capital Allocation Line: for a single portfolio vs for the whole market below
CML: Capital Market Line: the tangent line drawn from the point of the risk-free asset to the fea
27.a answers:
Information
Passive portfolio Active porfolio y = Active y-1 = Active ErC
Expected rate of return 13% 18% 0% 100% 8.0%
Standard deviation 25% 28% 10% 90% 9.0%
20% 80% 10.0%
Risk free rate 8% 30% 70% 11.0%
Sharpe 5/ 28 40% 60% 12.0%
50% 50% 13.0%
60% 40% 14.0%
Sharpe CAL 0.3571428571 70% 30% 15.0%
Sharpe CML 0.2 80% 20% 16.0%
90% 10% 17.0%
100% 0% 18.0%
27.b answers:
My Active fund has better returns for each given SD. So, if you only want a SD of 10%, you are more likely to have hig
Of course, you will pay for this in terms of active management fees lol.
et.
Ch. 5, problem 2
Ch. 5, problem 4
E(r) 𝜎^2
0.15575 0.029282947
0.042 0.0028812
-0.05775 0.004025897
0.14 0.036190044
MEAN Variance SD
Ch. 5, problem 13
will only invest if the Er minus risk free rate is GREATER than the risk premium.
if Er-rF > rP, then invest!
Portfolio / (rF + rP + 1)
e plus your risk premium. You want more than the risk premium, so you would pay less for the portfolio, NOT MORE.
Chart Title
2.5
2
Expected Return
1.5
0.5
0
0 0.2 0.4 0.6 0.8 1 1.2
SD
Ch. 6, problem 7
Ch. 6, problem 13
Ch. 6, problem 15
have the same Sharpe ratio.
Ch. 6, problem 17
he rF asset deviation?? Assume that risk free has 0 deviation? Well…it is supposed to.
Ch. 6, problem 19
market below
he risk-free asset to the feasible region for risky assets Slope of the Capital Market Line is the Sharpe Ratio
28.0% 0.18
12.0%
Expected Return
10.0%
Stan
2.0%
0.0%
17.5% 0.115 0.0% 5.0% 10.0%
20.0% 0.12 Stan
22.5% 0.125
25.0% 0.13
Standard Deviation
10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation
sk aversion.
Holding Period Return
Standard Deviation is RISK
Certainty Equivalent Rate
Indifference curve plotting the Expected Return against an investor's utility
Expected Value of the Return on the Portfolio
Standard Deviation of the value of the portfolio
Equation for the proportion of the amount to invest in risky asset, thus also the risk free asset.
Ch. 5, problem 2
You’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back
Question 1: What are the advantages and disadvantages in using these data to help estimate the expected rate of retu
Advantages: we have many data points to create a statistical average and predict the actions of the future. We ca
best with the present year. The larger the sample size the better
Disadvantages: The data that we have proves that some market conditions are only 20/20 in hindsight. Trying to
failure. The future is not DEPENDANT on the past, but follows the past. Er is a calculation of future values, no
have any bearing on the equation.
Ch. 5, problem 4
Answers:
Ch. 5, problem 7
Answers:
Ch. 5, problem 1
HPR 80%
inflation rate (r) 70%
Ch. 6,
4.a answers
4.b answers
If you purchased the portfolio at that price, the rate of return would be 14%, which is the risk free rate
4.c answers
PV 114407
4.d answers
If risk premium is higher (12%) we are willing to pay less (114.407), because we take more risk. And vi
Ch. 6,
Answers:
Ch. 6,
Information
Utility level U 0.05
Risk aversion A 4
see previous
Ch. 6, p
Ch. 6, p
Ch. 6, p
17.a answers: What is the proportion y?
T-bill rate(risk-free) 8%
E(r) p-portfolio 18%
E(r) c-complete 16%
17.b answers: What are you client's investment proportions in your 3 stocks and T-bill fund?
100.0%
17.c answers: What is the standard deviation on the rate of return on your client's portfolio?
Ch. 6, p
A: 3.5
19.a answers:
y 36.4%
1-y 63.6%
19.b answers:What is the expected value and standard deviation of the rate of return on your client's opt
Ch. 6, p
CAL: Capital Allocation Line: for a single portfolio vs for the whole market below
CML: Capital Market Line: the tangent line drawn from the point of the risk-free
27.a answers:
Passive portfolio (CML)
E(r) 13%
std dev 25%
Risk-free r 8%
Ch. 5, problem 2
mate the expected rate of return on U.S. stocks over the coming year?
the actions of the future. We can measure certain years or periods that correspond
ly 20/20 in hindsight. Trying to predict the future solely on the past will lead to
calculation of future values, not past values, so although old data helps, it doesn't
Ch. 5, problem 4
Ch. 5, problem 7
Ch. 5, problem 13
Ch. 6, problem 4
* t-bills is the foundation, wherefrom I start off and pile up with 8% on top
4%, which is the risk free rate plus your risk premium.
se we take more risk. And vice-verso, when we take a lower risk premium, we're paying more ,because less risk is implied
Ch. 6, problem 6
the higher U
0.200
0.180
0.160
0.140
0.120
0.100
0.080
0.060
0.040
0.020
0.000
0 0.05 0.1 0.15 0.2 0.25 0.3
Ch. 6, problem 7
Ch. 6, problem 13
Ch. 6, problem 15
Ch. 6, problem 17
ErC = ErP*y + rF - rF*y
y = [E(rC) - rF] / [ErP - rF]
lient's portfolio?
Ch. 6, problem 19
Ch. 6, problem 27
CAL: The CAL is derived with the risk-free and 'the' risky portfolio, P
CML: We call the capital allocation line provided by 1-month T-bills and a broad index of co
20.00%
18.00%
16.00%
14.00%
12.00%
10.00%
x - horizontal, std dev ------->
y - vertical, cml cal | 8.00%
6.00%
4.00%
2.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0% 5% 10% 15% 20% 25%
p(s) = probability 'of a scenario'
r(s) = HPR 'in each scenario'
yield + rate of capital gains
se less risk is implied
ate of return
crazy things, old people specifically
and a broad index of common stocks the Capital market line (CML)
5% 20% 25% 30% 35%
Ch. 7
Answers:
stock, bonds, cash, no debt
The Expected Return on a Portfolio is computed as the weighted average of the expected returns o
SD of the returns will increase or decrease risk based on how high the SD is.
Expected Return multiplied by SD to get the risk, right?
If Correlation with other assets is high, ie you have at REIT, then risk will be higher.
the minimum-variance portfolio has a standard deviation smaller than that of either of the individual component assets.
Answers:
Ch. 7
Answers:
Optimal allocation??
Formula on slide in lecture notes. Slide 30.
wS 0.4516
wB 0.5484
ErP 16%
SD P 17%
Ch. 7
Answers:
Ch. 7
E(r_C) 14%
Risk free rate 8%
Sharpe 0.460
SD.P
Answers 9.b:
Ch. 7,
Answers:
Stock E( r) σ
A 10% 5
B 15% 10
Correlation -1
w 40
1-w -39
Erp 4
Ch. 7,
Answers:
D, because the lower correlation you have, the more reduction in risk you receive per reduction in E(r).
Ch. 8
Answers:
alpha is a factor that affects the returns of a stock and does not affect the market.
Managers like it because they can take these stocks and get better returns (or worse losses) than the
market.
As alpha increases, the sharpe ratio decreases and the CAL line becomes flatter.
"The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk."
Ch. 8
Answers 6a:
Answers 6b:
Weight A 30%
Weight B 45% NonSys SD A 0.09
Weight C 25% NonSys SD B 0.18
0.2700
β 0.78 Correct Formula 0.00729
SD 0.00000
Er 14.00% 14%
Nonsystem SD -0.27
Ch. 8
Answers 7a.
Answers 7b.
Answers 7c.
Ch. 8
Answers:
σ_M 20%
R-square A 0.2
R-square B 0.12
Beta A 0.7
Beta B 1.2
SDEV Var_A 0.098
SD_A 31%
Var_B
SD_B
Ch. 8,
Answers:
e of the expected returns on the stocks which comprise the portfolio.
a and c Portfolio Risk is a measure of each of the assets' variace and SD, thus the new asset will affect n
Ch. 7, problem 4
Xa = (σ
THIS IS THE MINIMUM VARIAN
Cov = 45
Er 13.391304347826100%
Var 13.9174585386 SQRT!!!!
Ch. 7, problem 7
Ch. 7, problem 8
Ch. 7, problem 9
y = mx + b, sharpe is m
b=y-c/m
Erc - rf / ErP - rf
Ch. 7, problem 12
covariance of two stocks, then use the formula?
Then calculate weight for each stock
A: 66.67
B: 33.33
Value: 11.67
Ch. 7, problem 17
Ch. 8, problem 4
Ch. 8, problem 6
Var(A) = BA^@ * VarM + VarFirm-spec e?
?????
Ch. 8, problem 7
sk. It measures volatility. CapM calculates the expected return of an asset based on its beta (volatil
to get the covariance between mkt and stck, then get SD of stock?
B^2 * varM^2
D, thus the new asset will affect new risk
_A = BA^2*varM^2 / R^2
asset based on its beta (volatility) and expected returns.
Ch. 7, problem 2
Answers:
a) Standard deviation Portofolio variance now includes a variance term for rea
b) Correlation
Ch. 7, problem
Answers:
Minimum-variance/least risky portfolio (diff f
E(r_S) (D) 20%
E(r_B) (E) 12%
σS (D) 30%
σB(E) 15%
ρ (correla) 0.1
T-bill 8%
Covariance 0.0045 1,
Wmin (D) 17% 2,
Wmin (E) 83%
Ch. 7, problem 7
Answers:
Optimal risky portfolio (different from minim
E(r_S) (D) 20%
E(r_B) (E) 12%
σS (D) 30%
σB(E) 15%
ρ (correla) 0.1
T-bill 8%
W (S) 45% 1,
Wweight (E) 55% 2,
E(r) 15.6% 3,
variance 2.7% 4,
Std dev 16.5% 5,
Ch. 7, problem 8
Answers:
S 46.0%
Ch. 7, problem 9
E(rC) 14%
E(rP) 15.6% (above) (E(r) -risky portfolio
std dev P 16.5% (above)
t-bill 8% (above)
Answers 9.a:
Answers 9.b:
y (proportion) 78.8%
1-y (t-bill) 21.2%
a variance term for real estate returns and a covariance term for real estate returns with return for each of the other three a
Ch. 7, problem 4
ast risky portfolio (diff from optimal risky portfolio, which is next Q)
-1 correlation means they are completely opposite
+1 correlation means they are closely related
e std dev, we need to find out the variance, thus, find the VARIANCE formula
Ch. 7, problem 7
Ch. 7, problem 8
Ch. 7, problem 9
==> reversed formula because we need to find 'y', which is the ''prop
y = (ErC-rf)/(ErP-rf)
ach of the other three asset classes
nd 'y', which is the ''proportion''
Ch. 9, Problem 1
Answer
E(rp) 18%
rf 6%
E(rM) 14%
Beta 1.5
Ch. 9, Problem 2
Answer
E(ri) 14%
rf 6% new Er
Price 50 $
Mkt rPremium 8.0% Doubled = 16%
Beta 1 Market Risk Premium is the market return minus risk free rate
Beta x 2 2 Rearrange formula, calculate for Beta, then double.
rPremium 22.0% Use formula to determine Expected Risk Premium
Dividend 7 Dividend equals Expected return times the price
MktP 31.818181818 Mkt price is the dividends divided by the risk premium. Divide dividend per share by
DIVIDEND DISCOUNT MODE
Ch. 9, Problem 8
Answer 8a
rf 8% Years 1 2 3 4
E(rM) 16% -40 15 15 15 15
βproject 1.8 Discounted 12.254901961 10.012174805 8.1798813763 6.6829096211
Sum 58.092131897
NPV 18.0921318966 subtract debt 18.092131897
Highest Beta
IRR 35.7%
Calculate Beta 3.4667 This is the beta when you calculate IRR and the NPV is 0. IRR number is the rate of return a
Answer 8b
Ch. 9, Problem 17
Answer
rf 6%
E(rM) 16%
Stock price 50 $
Dividend 6$
βi 1.2
Erp 18%
New Price 33.3333333333 Price equals dividends divided by Risk Premium. We calculated expected future rP.
Actual new price $ 52.000
Ch. 9, Problem 20
Answer 20a
r1 19% Beta of 1.5 means the stock moves 50% more than the marke
r2 16%
β1 1.5 rM1 16.0000%
β2 1 rM2 16.0000%
Risk Free 10%
#1 0.1266666667 rM should be equal for both investors, set them equal and det
#2 0.16
Individual 1, because individual 2's return is the exact same as the market. In
We can't answer this because we need information about the market rate to determine abnormal returns, or a.
Answer 20b
rf 6%
rM 14%
rP 8%
r1 18% 1%
r2 14% 2% This investor's actual return is greater than his expected portfolio return, ther
Answer 20c
rf 3%
rM 15%
rP 12%
r1 21% -2%
r2 15% 1% Likewise, investor 2 is greater in this condition
Answer
Yes. The efficient market hypothesis states that the price reflects all known information. Know information displays the price.
The Law of One Price says that similarly valued alternatives should have the same ERR.
Answer
Not necessarily; New information causes changes in the price. Also, there is a lag in the amount of time from the information to
Rational markets say high volatility reflects crazy amount of new information.
Irrational theory says that it is true, the market doesn't really know what the price should be because it is full of irrational invest
High volatile prices reflects highly volatile expected returns. Seasonal stocks?
Answer
c, because this should be known by all people and thus the price would. This contradicts the weak-form hypothesis.
Answer 19a
rf 1%
rM 1.50%
β 2 MINUS RISK-FREE??? Or NOT?
Lawsuit gain 1
Equity 100
rr 3.00% rate of the market times the beta, plus the percent of gain divided by current equity. Minus ri
rr2 4.00% rate of return is one percent higher from the gain in lawsuit.
Er 2%
Lawsuit Gain changes because it was expected to be 2, and comes out as 1, there is a -1 lawsuit gain!
Answer 19b
rM 3%
rA 4%
rB 1.7%
Bpex would have won the lawsuit. Apex expected MORE than what they got, and Bpex received more than what the expected!!
Ch. 11, Problem 21
Answer 21a
E(rM) 12%
rf 4%
β 0.5
Equity 100 $
Er 8%
Er$$ 8 million
Answer 21b
Erm 10%
Er 7%
Answer 21c
Settlement 5 million
return 10%
Er 7%
Extra 3% Extra attribution, the amount the market did over the return
3 What is the surprise amount the firm earns from the settlement???
Prior expectation 2 Settlement minus the surprise amount
Ch. 11, Problem 23
Answer
If we predict the recession, it would already be reflected in the prices, thus you won't know if the price will change afterwards.
Answer
If the market expects EVEN HIGHER earnings than what was reported, then market will be pessimistic and price will fall.
Ch. 9, Problem 1
Ch. 9, Problem 2
22% P = CF / r
cash flow divided by risk
de dividend per share by required rate of return and you get the price of the stock.
IDEND DISCOUNT MODEL
Problem 8
5 6 7 8 9 10
15 15 15 15 15 15 -40
5.4598934813 4.4606972887 3.64436053 2.9774187336 2.4325316451 1.9873624552
h. 9, Problem 17
E(r) = (D +P1 - P0) / P0
xpected future rP. Can't use this equation because it was the formula for a perpetuity. This is not a perpetuity.
h. 9, Problem 20
ors, set them equal and determine what is the risk free rate.
xact same as the market. Individual 1 made 3% more than the other.
ected portfolio return, therefore this is the better investor.
h. 11, Problem 3
me from the information to the correct price reflection. Also there are anomolies.
h. 11, Problem 9
rm hypothesis.
h. 11, Problem 17
Problem 19
wer 19a
awsuit gain!
h. 11, Problem 20
re than what the expected!!
Problem 21
As we get new info expected retrun will change and price will ch
h. 11, Problem 23
h. 11, Problem 26
Answer
Behavioral Biases
Framing If you tell a kid about compound interest, show him that a few dollars a month adds up to millions in you
Mental Accounting Good if you spread your risk even more…one portfolio may be retirement fund, another might be vacatio
Regret Avoidance Young people who start investing will be discouraged if they lose money and begin investing in an ETF
Technical Trading Rules: look at a price and it goes up and down and up and down, we assume it will follow a pattern because
Why would an advocate of the efficient market hypothesis believe that even if many investors exhibit the behavioral
Answer
This is because some investors are irrational, but as long as there are SOME rational investors, they will exploit and a
Answer
Arbitrage
Costs of trading might exceed the minimal arbitrage benefit.
Faulty models might give you a benefit that doesn't exist in reality
Fundamental Risk: "markets are inefficient longer than you can stay solvent??"
Implementation Costs: cost of trading and implementing the arbitrages
Model Risk: your model might be wrong!!
Ch. 12, Problem 11
Answer
Because, if you mine enough data, you are garunteed to find a small percentage of random statistically significant co
We believe we have found a pattern which in fact does not exist. The so called 'pattern' might actually just be random
You have a utility function U = E ( r%) - 0.5 Aσ ( r%) with A = 3. You have three assets to invest in: asset A with expec
2
and a return standard deviation of 0.3, and a risk-free asset with a return of 0.02. The correlation coefficient between re
correlation is -0.2.
a)
Illustrate graphically the difference in portfolio opportunity sets (feasible combinations in expected return-standard dev
if the beliefs were both true, and explain why they are different.
Answer
A 3
E(rA) 7% U.A 6.90625%
E(rB) 15% U.B 14.86500%
σA 0.25 Portfolios A B
σB 0.3 1 1 0
rf 2% 2 0.9 0.1
ρABreal 0.4 3 0.8 0.2
ρABbias -0.2 4 0.7 0.3
5 0.6 0.4
6 0.5 0.5
7 0.4 0.6
wA real 8% 8 0.3 0.7
wB real 92% 9 0.2 0.8
wA bias 42% 10 0.1 0.9
wB bias 57.9% 11 0 1
The Bias case gives us an estimate that we can have the SAME RETURN for a lower SD!!
If there was no correlation, the line would be completely vertical, with all portfolios having the same SD.
But since there is a correlation, the line is non linear
Calculate the optimal risky portfolios with the true correlation coefficient and your subjective belief, as if the respective
Answer
E(rA) D 7
E(rB) E 15 SD P Er P real Er P bias
σA D 25 0% 2.00% 2.00%
σB E 30 3% 3.09% 3.22%
rf 2% 5% 4.18% 4.43%
ρABreal 40 8% 5.27% 5.65%
ρABbias -20 10% 6.36% 6.86%
13% 7.45% 8.08%
Real Bias 15% 8.54% 9.29%
18% 9.63% 10.51%
20% 10.72% 11.72%
ErP 14% 11.6% 23% 11.81% 12.94%
SD P 28.3% 19.8% 25% 12.90% 14.15%
Sharpe 0.44 0.49 28% 13.99% 15.37%
30% 15.08% 16.59%
33% 16.17% 17.80%
35% 17.25% 19.02%
38% 18.34% 20.23%
Find the allocations between the optimal risky portfolio and the risk-free asset under the different beliefs. Why do you choose t
Answer
Real Bias
A 3 y 0.51 0.82
rf 0.02 y-1 0.49 0.18
e)
What is your utility loss from having incorrect beliefs? How would you evaluate the magnitude of this loss in terms fundamenta
Answer
U = E ( r%
) - 0.5 Aσ 2 ( r%)
U = E ( r%
) - 0.5 Aσ 2 ( r%) U real U bias
14.2% 11.6%
Real Bias
Er C 8.33% 9.88% What must the return on the regular portf
SD C 14.53% 16.21%
f)
How much of the expected return of the optimal risky portfolio constructed with correct beliefs about return characteristics wou
about the correlation between the assets?
Answer
I would be willing to lose up to 2.5% which would put me at equal return as the incorrect belief portfolio??
g)
Now, assume that your utility function is characterized by A = 8. How do your answers to questions 1d) through 1f) change? Gi
of risk aversion and the impact of a bias in the belief about the correlation between asset returns?
Answer
When Standard Utility rises the Utility decreases because the formula subtracts from SD.
Ch. 12, Problem 1
any investors exhibit the behavioral biases discussed in the chapter, securty prices might still be set efficiently?
nal investors, they will exploit and arbitrage the misprices out of the market.
of random statistically significant correlations that in fact have no bearing on the stock value.
attern' might actually just be random occurrence of the lifetime of the stock.
assets to invest in: asset A with expected return 0.07 and a return standard deviation of 0.25, asset B with expected return 0.15
he correlation coefficient between returns of assets A and B is 0.4. However, due to a behavioural bias you believe that the
ions in expected return-standard deviation space) stemming from combinations of the risky assets under the different beliefs, as
16.0%
14.0%
Er SD real SD bias
7.0% 0.250 0.250
12.0%
7.8% 0.239 0.221
8.6% 0.231 0.197
10.0%
9.4% 0.227 0.180
10.2% 0.226 0.172
8.0%
11.0% 0.230 0.175
11.8% 0.238 0.188
12.6% 0.250 0.208 6.0%
0.0%
0.160 0.180 0.200 0.220 0.240 0.260 0.280 0.3
2.0%
subjective belief, as if the respective beliefs were correct, and draw the different capital allocation lines.
35.00%
30.00%
25.00%
20.00% Er P rea l
Er P bi as
Compl ete Portfol i o
15.00% Effici ecy rea l
Effici ecy bi as
10.00%
5.00%
0.00%
0% 5% 10% 15% 20% 25% 30% 35% 40%
different beliefs. Why do you choose to hold a larger fraction of the optimal risky security in one scenario compared to the other?
If the correlation is negative, you allocate more money in risky portfolio because it equals the sa
at must the return on the regular portfolio be so that the Utility of the actual portfolio = the biased portfolio??
beliefs about return characteristics would you be willing to give up in order to be equipped with correct instead of incorrect beliefs
o questions 1d) through 1f) change? Give an intuitive interpretation of the differences in results. What do you conclude about the degree
returns?
efficiently?
th expected return 0.15
ou believe that the
Real
Bi as
Er real Er Bias
0.02 0.02
14% 12%
SD real SD bias
0 0
0.28 0.20
rtfolio because it equals the same amount of SD for a higher expected return.
SD Er
0% 14.22%
d of incorrect beliefs 3% 14.31%
5% 14.59%
8% 15.06%
10% 15.72%
13% 16.56%
15% 17.59%
18% 18.81%
20% 20.22%
23% 21.81%
25% 23.59%
28% 25.56%
30% 27.72%
33% 30.06%
35% 32.59%
conclude about the degree
The two indifference curves will not be the same, the biased utility is slightly lower thus
d utility is slightly lower thus making a less efficient use of the portfolio. It is NOT tangent to the CAL.
Maturity Settlement Coupon Bid Asked Asked Yield
4/30/2019 4/30/2018 1.25% 99.0859 99.1016 0.212%
4/30/2024 4/30/2018 2.00% 96.1797 96.1953 0.269%
Consider a 3.5% coupon bond with a maturity of four years. The bond pays annual coupon payments and has a face
curve over the one to five year maturity spectrum is given by:
Maturity 1 2 3 4 5
YTM 2.50% 3.00% 3.50% 4.00% 4.25%
Purchase 1/1/2018
maturity yrs 1/1/2022 Maturity 1 2
Coupon rate 3.50% $35.00 CF $35.00 $35.00
Maturity yrs 4 PV 34.14634146 32.99085682
Face value $1,000 bond price
Bond Value
YTM 0.03956 =YIELD() YTM PV 33.66806376 32.38681478
Use goal seek to set YTM PV bond value equal to bond bond price
face value, then change YTM
Year 1 35 0.975609756 34.14634146
Year 2 35 0.942595909 65.98171364
Year 3 35 0.901942706 94.7039841
Year 4 1035 0.854804191 3538.889351
SUM 3733.72139
Macauly's # 3.73 (Less than the time to maturity)
Periods 30 FV 1000
Settlement 1/1/2018
Maturity 1/1/2048
coupon 12% 120
duration 11.54
convexity 192.4
Price $1,450.31 $1,620.45 $1,308.21
YTM 7% 8% 9%
=DURATION() 12.309353556 11.5471407 10.83720245
=MDURATION() 11.504068744 10.69179694 9.94238757
2 100 90.122 The difference in value here and on the website is slight and
3 4
$35.00 $1,035.00
31.5679947 884.7223377158
983.4275306972
31.15432415 886.218346038
983.4275487325
0.00001804
me to maturity)
Forward Rate = -1 + [ (1+YTM)^n / (1+YTM1-n)^1-n ]
If the forward rate is greater than the previous forward rate,
maturity 1 2 3
Weight 3.47% 3.35% 3.21%
Individual Duration 0.034721767 0.067093621 0.096299911
price plus 35 divided by old price -1 Bond Duration
Time Period
Coupon Payment
y = periodic yield maturity 1
n = periods YTM 2.50%
M = maturity value Forward 2.500%
n / (1+YTM1-n)^1-n ]
n the previous forward rate, then forward rate is greater than YTM
4
89.96% Weight = PV / Bond Price
3.598525809 D = weight * Time
3.796641108 SUM()
ccount. But, as it is, we can use the modified duration to create a more accurate curve.
es in YTM we need to account for maturity.
ration changes along the price-yield curv
Question 1: What annual probability of default would be consistent with the yield to maturity of these bonds in
CAPM 3.56%
Annual probability 26.42%
Question 2: In mid-2015, Rite-Aid's bonds had a yield of 8,8%, whilse similar maturity Trea
Question 1: Use the estimates in Table 12.3 to estimate the debt beta for each firm (Use an average if multiple r
Debt Beta
Delta Airlines 0.17 From Chart
Southwest Airlines 0.075
Jetblue Airways 0.285
Continental Airlines 0.26
Average 0.749712741
Risk-free rate: 2%
Market risk premium: 4%
if they mention perpetual growth, USE IT!
Soft drink:
Cash flow this year: 76 million
Asset beta: 0.53
Anticipated growth rate: 4%
CAPM 6.56%
Value 964.91 million
SUM 64,298.25
Question 2: Estimate Weston's current equity beta and cost of capital. Is the cost of capital useful for valuing W
How is Weston's equity beta likely to change over time?
Question 2: Suppose the risk-free interest rate is 5%. If WT borrows $52 million today at this rate and uses the
value of its equity just after the dividend is paid, according to MM?
Risk-free rate: 5%
New debt: 52 million
New Equity 205
MM1 says that value of firm doesn't depend on capital structure
Question 3: What is the expected return of WT stock after the dividend is paid in part 2?
Question 1: According to the MM proposition I, what is the stock price for Omega Technology?
Alpha:
Shares outstanding: 14 million
Price per share: 24 $
Market Value 336 million
Omega Tech:
Shares outstanding: 22 million
Debt 100 million
Stock Price 15.27 $
Question 2: Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity
opportunity?
Question 2: Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity
opportunity?
Question 2: Suppose you are a shareholder holding 100 shares, and you disagree with this decision.
Assuming a perfect capital market, describe what you can do to undo the effect of this decision.
Take on more debt, in a perfect market the debt does not change total value.
Company has 100 million outstanding shares, they want to remove shares, so they romove debt, then they take out
For us to have leverage with debt, we need to borrow debt to buy 27.xx shares. Now your portfolio will have 127.xx s
0.274376417
27.43764172 x100
1169.082126 x share price
Question 1: According to MM Proposition I, what is the value of the equity? What are its cash flows if the econ
economy is weak?
Value of project: 1000
Value of debt 750
Required return on debt: 5% risk-free rate
Question 2: What is the return of the equity in each case? What is its expected return?
Strong Weak
Return 145% -55%
Prob 0.5 0.5 We just assume that there is a 50/50 c
Question 3: What is the risk premium of equity in each case? What is the sensitivity of the levered equity retur
How does its sensitivity compare to that of unlevered equity?
Risk premium of levered equity 40% Expected return minus required return
WAAC =250/1000*C279+750/1000*x
Ch. 14, problem 13
Suppose Visa Inc. (V) has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the credi
average amount of debt for its industry at a cost of debt of 6%?
Question 1: Suppose GP issues $299 million of new stock to buy back the debt. What is the expected return of t
Question 2: Suppose instead GP issues $71 million of new debt to repurchase stock.
i. If the risk of the debt does not change, what is the expected return of the stock after this transac
ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than
Problem 1
Pelamed Pharmaceuticals has EBIT of $133 million in 2006. In addition, Pelamed has interest expenses of $49 millio
EBIT 133
Interest 49 84 54.6
Tax rate: 35%
Income 54.6
EBT 84
Tax 29.4
Net Income 54.6
Question 2: What is the total of Pelamed’s 2006 net income and interest payments?
Question 3: If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to y
Question 1
Question 1: How much will debt holders receive after paying taxes on the interest they earn?
Question 2: By how much will the firm need to cut its dividend each year to pay this interest expense?
Question 3: By how much will this cut in the dividend reduce equity holders’ annual after-tax income?
Question 4: How much less will the government receive in total tax revenues each year?
p is probability of default
L is expected loss of 1$
expected return of the bond is….
ME AS ABOVE
What is t???
Asset Beta
0.727799042
0.770523064
0.797516451
0.703012408
Ch. 12, problem 23
Value = CF / r - g
cost of capital useful for valuing Weston's projects?
30.35%
ion today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market
d in part 2?
mega Technology?
are. What arbitrage opportunity is available? What assumptions are necessary to exploit this
THIS IS ALWAYS AT THE EXAMS!!!!
398 million
y romove debt, then they take out equity and have NO DEBT anymore
ow your portfolio will have 127.xx shares instead of 100!
What are its cash flows if the economy is strong? What are its cash flows if the
U is market value of equity
A is market value of assets
just assume that there is a 50/50 chance of one condition vs the other.
s required return risk premium equals exp return minus risk free rate
83%
debt to equity value. To get value you just take 100% minus debt
has interest expenses of $49 million and a corporate tax rate of 35%.
est payments
each year?
Tc = corporate tax rate
Ti = interest tax
Te = equity tax, or dividends tax which are payed as income to shareholders
of the bond is….
87.619047619
return
14.13%
14.13%
2.72%
-8.70%
f) What is the total value of the project when financed in part with leverage?
g) How do your above answers to problem 1 a) – 1 f) change if there is a 25% loss in value in the event of a defa
YTM 0.226993865
Return 9955%
9955%
6705%
5955%
Problem 2
You are given the following table showing the market value of equity,
the market value of debt and equity beta estimated following the CAPM for five firms.
a) Given the knowledge that the level of debt has been randomly assigned to these firms akin to an experiment
belong to the same industry, which firms do you think belong to the same industry?
Firms A and B belong to the same industry, as well as firms D and E because their Beta's are similar.
Firm Equity Debt Beta (equity) E/V Beta Unlevered
A 100 150 2.25 0.4 0.9
B 100 50 2.25 0.666666667 1.5
C 100 90 2.85 0.526315789 1.5
D 100 80 2.7 0.555555556 1.5
E 100 200 2.7 0.333333333 0.9
b) How would you answer to part a) change if the level of debt were not randomly assigned to firms?
If debt were actual, and not assigned, then I woul definitely change; within an industry, many firms have similar debt-
Services and capital goods industries usually have larger cash reserves to account for seasons and financial difficulty.
We assume firms in the same industry have approximately the same capital structure.
Problem 3
The following table contains estimates of the present value of
tax shields and probabilities of financial distress for different levels of debt.
0 40 50 60 70
PV of tax shield 0 0.76 0.95 1.14 1.33
Prob of distress 0% 0% 1% 3% 7%
Distress Cost 1 1 1 1 1
PV Distress 0 0 0.0095238095 0.028571429 0.066666667
Net benefit 0 0.76 0.9404761905 1.111428571 1.263333333
Find the optimal level of debt for financial distress costs between 1 and 25 with increments of 1. Hint: The MA
problem.
MAX() returns the highest value in an array
INDEX() returns a cell value (x,y) based on an array
MATCH() finds a value, or the closest substitute and returns the position based on an a
Risk free rate 5%
Distress Cost 1 Use the Data Table What If function, and only input in the row cell…refer to d
Distress cost
0.00 0.00 0.76 0.94 1.11 1.26
1.00 0.94 1.11 1.26
2.00 0.93 1.08 1.20
3.00 0.92 1.05 1.13
4.00 0.91 1.03 1.06
5.00 0.90 1.00 1.00
6.00 0.89 0.97 0.93
7.00 0.88 0.94 0.86
8.00 0.87 0.91 0.80
9.00 0.86 0.88 0.73
10.00 0.85 0.85 0.66
11.00 0.85 0.83 0.60
12.00 0.84 0.80 0.53
13.00 0.83 0.77 0.46
14.00 0.82 0.74 0.40
15.00 0.81 0.71 0.33
16.00 0.80 0.68 0.26
17.00 0.79 0.65 0.20
18.00 0.78 0.63 0.13
19.00 0.77 0.60 0.06
20.00 0.76 0.57 0.00
21.00 0.75 0.54 -0.07
22.00 0.74 0.51 -0.14
23.00 0.73 0.48 -0.20
24.00 0.72 0.45 -0.27
25.00 0.71 0.43 -0.34
Which type of firm is more likely to experience a loss of customers in the event of financial distress:You have received
B offers to pay you $83,000 for two years. Both jobs are equivalent. Suppose that firm A’s contract is certain, but that
event, it will cancel your contract and pay you the lowest amount possible for you not to quit. If you did quit, you exp
unemployed for three months while you search for it.
a) Say you took the job at firm B. What is the least Firm B can pay you next year in order to match what you w
Value
Discounted Value
b) Given your answer to part (a), and assuming your cost of capital is 5%, which offer pays you a higher prese
Year 1 Year 2
Salary A 79000.00 79000.00
Salary B 83000.00 59250.00
Cost of capital 5%
Increasing the risk of bankruptcy increases the chance of lost income from finding a new job, which decreases the ov
Thus, increasing wage proportional to the risk of bankrupcy accounts for the chance that you will lose your job and n
A 90
B 80
C 55
b) Suppose Zymase has debt of $35 million due at the time of the project’s payoff. Which project has the highe
Debt 35 m
c) Suppose Zymase has debt of $130 million due at the time of the project’s payoff. Which project has the high
Debt 130 $m
d) If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agenc
expected agency cost to the firm from having $130 million in debt due?
Strategy
A B C D
Probablity of succes 93% 77% 61% 45%
Firm value 55 63 71 79
Assume that for each strategy, firm value is zero in the event of failure.
A B C B
Value 51.15 48.51 43.31 35.55
b) Suppose Petron’s management team will choose the strategy that leads to the highest expected value of Petr
has:
(i) No debt?
(ii) Debt with a face value of $16 million?
(iii) Debt with a face value of $32 million?
a) What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of it
Tax 0
Risk free rate 0%
Face value of debt 32
b) Suppose Petron issues equity and buys back its debt, reducing the debt’s face value to $4 million. If it does s
the firm increase?
Debt 4 $m
c) Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to
debt?
c) Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to
debt?
There is a RISK FREE RATE
So, the face value is equal to the debt value
We want 32-4 = 28million. There is no discounting or interest rate to speak of, so we just ask for the face value of the
d) Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back th
e) How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders
its leverage?
Equity holders
Equity value after 47.43 debt of 4
Equity holders buy back 28
Net Payoff to equity holders 19.43
If no buyback, value to equity holder 23.87 debt of 32
Loss from buyback 4.44
Debt Holders
receive from equity holders 28
still hold in risk-free debt 4
Total payoff 32 Increase in value
Worth if no buyback 24.64
Gain 7.36
Ch. 16, problem 24
You own your own firm, and you want to raise $30 million to fund an expansion. Currently, you own 100% of the firm
equity, you will need to sell two-thirds of the firm. However, you would prefer to maintain at least a 50% equity stake
a) If you borrow $20 million, what fraction of the equity will you need to sell to raise the remaining $10 million
30m / .67 45
New Proportion 22% sell this amount of the firm
b) What is the smallest amount you can borrow to raise the $30 million without giving up control? (Assume pe
a) If Ralston has debt due of $70 million in one year, the CEO’s decision will increase the probability of bankru
b) What level of debt provides the CEO with the biggest incentive not to proceed with the decision?
Probability is the highest at a debt of 85-105, so there is a greater chance of paying back the debt. Probability is with
Ch. 16, problem 30
According to the managerial entrenchment theory, managers choose capital structures so as to preserve their cont
losing control in the event of default. On the other hand, if they do not take advantage of the tax shield p
Suppose a firm expects to generate free cash flows of $90 million per year, and the discount rate for these cash flo
firm and finance it with $750 million in permanent debt. The raider will generate the same free cash flows, and the
over the current value of the firm. According to the managerial entrenchment hypothesis
Premium 20%
ms akin to an experiment, the market is otherwise perfect, all debt is risk free, and not all firms
We can assume A and E are same, and BCD are the same, but HARD TO SAY!
igned to firms?
ny firms have similar debt-equity ratios. In medical field they are comprised of mostly debt due to high cost of research until me
ns and financial difficulty.
Problem 3
80 90
1.52 1.71
16% 31%
1 1 Distress is 1 EVERY TIME. Simulate for 1
0.152380952 0.2952380952
1.367619048 1.41
ments of 1. Hint: The MAX(), INDEX() and MATCH() functions in excel are useful in solving the
h. 16, problem 7
distress:You have received two job offers. Firm A offers to pay you $79,000 per year for two years. Firm
ontract is certain, but that firm B has a 50% chance of going bankrupt at the end of the year. In that
it. If you did quit, you expect you could find a new job paying $79,000 per year, but you would be
h. 16, problem 20
ifferent research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below.
ich project has the highest expected payoff for equity holders?
Choose B
hich project has the highest expected payoff for equity holders?
Choose C
hat is the expected agency cost to the firm from having $35 million in debt due? What is the
WRONGGGGGGGGG
h. 16, problem 21
There are four options, each with a different probability of success and total firm value in the event of
st expected value of Petron’s equity. Which strategy will management choose if Petron currently
35.55
D Max Equity Value Expected equity value = Probability * (firm value - debt)
35.55 A
28.35 A
21.15 B
45%
55%
h. 16, problem 22
f $32 million outstanding. For simplicity, assume all risk is idiosyncratic, the risk-free interest rate is zero,
maximizes the value of its equity? What is the total expected value of the firm?
to $4 million. If it does so, what strategy will it choose after the transaction? Will the total value of
x Equity Value
If you expect the firm to reduce its debt to $4 million, what price would you demand to sell your
sk for the face value of the debt
w much will debt holders gain or lose? Would you expect Petron’s management to choose to reduce
h. 16, problem 24
you own 100% of the firm’s equity, and the firm has no debt. To raise the $30 million solely through
t least a 50% equity stake in the firm to retain control.
Firm Value 15
h. 16, problem 26
ce the value of the firm’s assets by $10 million. The CEO is likely to proceed with this decision unless it substantially increases th
7% 3%
115 125
45 55
the decision?
o as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk
vantage of the tax shield provided by debt, they risk losing control through a hostile takeover.
ount rate for these cash flows is 10%. The firm pays a tax rate of 40%. A raider is poised to take over the
me free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20%
entrenchment hypothesis, what level of permanent debt will the firm choose?
Consider the example of Avco, Inc., evaluating a new investment project. The investment project has identical risk to a publicly
covariance with the market portfolio than Avco, but has the same D/E ratio and cost of debt as Avco. The project will have sales
a rate of 5% for 4 years, and then remain constant at the same level for an additional 3 years, for a total project life span of 8 y
million and $9 million the first year, and will remain a constant fraction of sales throughout the life of the project. Upfront R&D
necessary investment in equipment of $30 million is depreciated via the straight-line method over the life of the project. The pr
identical to Avco’s capital structure excluding the project. The tax rate is 40%, and there is no net working capital. The risk free
portfolio is 9%.Without the project, Avco has a cost of capital of 6% for debt and 10% for equity.
Question a: What are the sales, gross profit, EBIT, unlevered net income and free cash flow throughout the life of the pr
Million $ Year 0 1 2 3
Sales $ 60.00 $ 63.00 $ 66.15
Costs of goods sold $ (25.00) $ (26.25) $ (27.56)
Costs / Sales Ratio $ 0.42 $ 0.42 $ 0.42
Gross Profit $ 35.00 $ 36.75 $ 38.59
Operating Expenses $ (10.00) $ (9.00) $ (9.45) $ (9.92)
OE / Sales Ratio $ 0.15 $ 0.15 $ 0.15
Depreciation $ (3.75) $ (3.75) $ (3.75)
EBIT $ (10.00) $ 22.25 $ 23.55 $ 24.92
Income Tax at 40% $ 4.00 $ (8.90) $ (9.42) $ (9.97)
Unlevered Net Income $ (6.00) $ 13.35 $ 14.13 $ 14.95
NPV $ 76.84
Question d: What is the project's levered continuation value throughout the life of the project? Calculate the levered con
continuation value and free cash flow
0 1 2 3
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70
Levered Value $ 112.84 $ 104.09 $ 93.92 $ 82.17
r(waac) 7.4%
Question e: Find the debt capacity throughout the life of the project.
0 1 2 3
Free Cash Flow(FCF) $ (36.00) $ 17.10 $ 17.88 $ 18.70
d = 50%
D(t) $ 56.42 $ 52.05 $ 46.96 $ 41.08
Levered Value
Debt must increase $ 285.43
Question f: What is the net borrowing throughout the life of the project?
Question g: What fraction of the value of the project stems from tax shields?
Question h: Calculate the free cash flow to equity and its present value.
Suppose Caterpillar, Inc., has 666 million shares outstanding with a share price of $73.09 and $24.41 billion in debt. If in
$86.62 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio?
In 2015, Intel Corporation had a market capitalization of $134 billion, debt of $13.2 billion, cash of $13.8 billion, and EB
repurchase, which market imperfections would be most relevant for understanding the consequence for Intel's value? W
Backcountry Adventures is a Colorado-based outdoor travel agent that operates a series of winter backcountry huts.
million. But profits will depend on the amount of snowfall: If it is a good year, the firm will be worth $5 million, and i
managers always keep the debt to equity ratio of the firm at 25%, and the debt is riskless.
Question b: Calculate the percentage change in the value of the firm, its equity and debt once the level of snowfall is rev
its target debt to equity ratio.
NEW VALUES Firm Value Value % Debt % Equity %
Good State 5 42.86% 0.00% 53.57%
Bad State 2.5 -28.57% 0.00% -35.71%
Question c: Calculate the percentage change in the value of outstanding debt once the firm adjusts to its target debt to e
Firm Value Equity Value Debt Value D/V Ratio D/E Ratio
Good State $ 5.00 $ 4.00 $ 1.00 20.00% 25.00%
Bad State $ 2.50 $ 2.00 $ 0.50 20.00% 25.00%
Question d: What does this imply about the riskiness of the firm's tax shields? Explain.
Because the debt is riskless, the only risk to the tax shields is the amount of outstanding debt. This risk is identical to
shields are identical to the riskiness of the firm as a whole.
Debt is riskless, so the firm's tax shields change with the firm's level of debt. Risk of Tax Shield is equal to risk of firm
In year 1, AMC will earn $2100 before interest and taxes. The market expects these earnings to grow at a rate of 2.7% per year
depreciation) or changes to net working capital. Assume that the corporate tax rate equals 42%. Right now, the firm has $5250
so that on average the debt will grow by 2.7% per year. Suppose the risk-free rate equals 4.5%, and the expected return on the
In year 1, AMC will earn $2100 before interest and taxes. The market expects these earnings to grow at a rate of 2.7% per year
depreciation) or changes to net working capital. Assume that the corporate tax rate equals 42%. Right now, the firm has $5250
so that on average the debt will grow by 2.7% per year. Suppose the risk-free rate equals 4.5%, and the expected return on the
Question a: If AMC were an all-equity (unlevered) firm, what would its market value be?
EBIT $ 2,100.00
Corporate Tax Rate 42.00% UNLEVERED FCF = EBIT * (1-T(c))
Risk-free rate 4.50%
Industry Asset Beta 1.27
Growth Rate of Unlevered 2.70%
Market Rate 9.90%
Question b: Assuming the debt is fairly priced, what is the amount of interest AMC will pay next year? If AMC's debt is
expected to grow?
Question d: Using the APV method, what is AMC's total market value, V(L)? What is the market value of AMC's equity
V(U) + ITS $ 1,146.05 How to get total market value???
Total Mkt Value $ 15,213.96
Total Equity Value (-debt) $ 9,963.96
Question e: What is AMC's WACC? (Hint: Work backward from the FCF and V(L))
Question f: Using the WACC, what is the expected return for AMC equity?
Equity Beta 1.94 Debt Beta is ignored, rearrange formula for Beta Equity
The will receive growth rate of debt * current year's debt * return on debt
2.7%!
Amarindo, Inc. (AMR), is a newly public firm with 10.5 million shares outstanding. You are doing valuation analysis of AMR. You
expect the firm's free cash flow to grow by 4.4% per year is subsequent years. Because the firm has only been listed on the stoc
equity beta. However, you do have beta data for UAL, another firm in the same industry:
AMR has a much lower debt-equity ratio of 0.36, which is expected to remain stable, and its debt is risk-free. AMR's corporate t
market portfolio is 11.3%.
Value $ 232.18
as identical risk to a publicly traded firm whose return on equity has a 20% higher
o. The project will have sales of $60 million the first year, after which the sales will grow by
a total project life span of 8 years. Manufacturing costs and operating expenses are $25
of the project. Upfront R&D expenses of $10 million is immediately tax deductible, while
the life of the project. The project will be financed with equal amounts of debt and equity,
orking capital. The risk free interest rate is 4% and the expected return on the market
Beta
Manufacturing Fraction
Operating Exp Fraction
D/E
Tax Rate
hroughout the life of the project? Risk-free Rate
Market Premium
4 5 6 7 8 Debt CoC
$ 69.46 $ 72.93 $ 72.93 $ 72.93 $ 72.93 Equity CoC
$ (28.94) $ (30.39) $ (30.39) $ (30.39) $ (30.39)
$ 0.42 $ 0.42 $ 0.42 $ 0.42 $ 0.42
$ 40.52 $ 42.54 $ 42.54 $ 42.54 $ 42.54
$ (10.42) $ (10.94) $ (10.94) $ (10.94) $ (10.94)
$ 0.15 $ 0.15 $ 0.15 $ 0.15 $ 0.15
$ (3.75) $ (3.75) $ (3.75) $ (3.75) $ (3.75)
$ 26.35 $ 27.85 $ 27.85 $ 27.85 $ 27.85
$ (10.54) $ (11.14) $ (11.14) $ (11.14) $ (11.14)
$ 15.81 $ 16.71 $ 16.71 $ 16.71 $ 16.71
is this right?
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46
4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46
? Calculate the levered continuation value as the discounted sum of the next period's
4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46 Levered Value = (FCF + V(L))
$ 68.69 $ 53.31 $ 36.79 $ 19.05 $ - USE EQUATION 18.4
4 5 6 7 8
$ 19.56 $ 20.46 $ 20.46 $ 20.46 $ 20.46
r 18, Problem 2
$24.41 billion in debt. If in three years, Caterpillar has 709 million shares outstanding trading for
ratio?
Million
Chapter 18, Problem 3
ash of $13.8 billion, and EBIT of nearly $16 billion. If intel were to increase debt by $1 billion and use the cash for a share
quence for Intel's value? Why?
might be a negative signal to investors that they need cash or need control of their company. Increasing debt is usually a good s
h is best, then debt, then raising equity.
roblem 4
the level of snowfall is revealed, but before the firm adjusts the debt level to achieve
djusts to its target debt to equity ratio.
𝚫�=(�_𝟏−�_𝟎)/�_𝟎
𝚫�=(�_𝟏−�_𝟎)/�_𝟎
𝚫�=(�_𝟏−�_𝟎)/�_𝟎
ebt. This risk is identical to the risk of the firm as a whole, so the riskiness of the tax
18, Problem 12
w at a rate of 2.7% per year. The firm will make no net investments (i.e. capital expenditures will equal
ight now, the firm has $5250 in risk-free debt. It plans to keep a constant ratio of debt to equity every year,
d the expected return on the market equals 9.9%. The asset beta for this industry is 1.27.
Unlevered FCF $ 1,218.00
of AMC's debt is uncertain, so the exact amount of the future interest payment is risky. Assuming the
MC's interest tax shield?
FCFE Method
18, Problem 14
luation analysis of AMR. You estimate its free cash flow in the coming year to be $15.37 million, and you
s only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's
s risk-free. AMR's corporate tax rate is 25%, the risk-free rate is 5.5%, and the expected return on the
g debt is usually a good signal that they can deal with the issue.
CAPM
Ch. 20, probl
The common stock of the P.U.T.T Corporation has been trading in a narrow range for the past month, and you are convinced it
however. The current price of the stock is $100 per share, and the price of a 3-month call option at an exercise price of $100 is
Question 1: What is the price of a 3-month put option with exercise price $100 (risk freee rate is 10%)
C 10
S 100
X 100
risk free 0.1
T 0.25
The difference between the two is due to rounding error from the exponential formula within excel
Question 2: What would be a simple options strategy to exploit your belief about the future stock price movement, and w
A good strategy is to purchase a put option AND a call option to create a short term hedge or protection against losses.
Because it is a out option, the price should decrease for the value of the option to increase.
*strattle*
An investor purchases a stock for $38 and a put for $0.50 with a strike price of $35. The investor sells a call for $0.50 with a st
Question 1: What is the maximum profit and loss for this position?
Question 2: Draw the profit and loss diagram for this strategy as a function of the stock price at expiration.
Chart Title
3
0
28 30 32 34 36 38
-1
-2
-3
-4
In this problem, we derive the put-call parity relationship for European options on stocks that pay dividends before option expir
the option.
Question 1: What is the value of a stock-plus-put position on the expiration date of the option?
Question 2: Now consider a portfolio comprising a call option and a zero-coupon bond with the same maturity date as th
should find that its value equals that of the stock-plus-put portfolio regardsless of the stock price.
Question 3: What is the cost of establishing the two portfolios in Q1 and Q2? Derive the put-call parity relation by equa
0 0 30 0 30
10 0 30 0 30
20 0 30 0 30
30 0 30 0 30
40 0 30 0 30
50 0 30 0 30
60 0 30 0 30
70 0 30 0 30
80 0 30 0 30
90 0 30 0 30
100 0 30 0 30
110 10 30 0 40
120 20 10 0 30
130 30 -10 10 30
140 40 -30 20 30
150 50 -50 30 30
160 60 -70 40 30
170 70 -90 50 30
Question 2: A vertical combination is the purchase of a call with exercise price X2 and a put with exercise price X1, with
0 100 0 100
10 90 0 90
20 80 0 80
30 70 0 70
40 60 0 60
50 50 0 50
60 40 0 40
70 30 0 30
80 20 0 20
90 10 0 10
100 0 0 0
110 0 0 0
120 0 10 10
130 0 20 20
140 0 30 30
150 0 40 40
160 0 50 50
170 0 60 60
A bearish spread is the purchase of a call with exercise X2 and the sale of a call with exercise price X1, with X2 greater than X1
0 15 0 15
10 15 0 15
20 15 0 15
30 15 0 15
40 15 0 15
50 15 0 15
60 15 0 15
70 15 0 15
80 15 0 15
90 15 0 15
100 15 0 15
110 5 0 5
120 -5 10 5
130 -15 20 5
140 -25 30 5
150 -35 40 5
160 -45 50 5
170 -55 60 5
An executive compensation scheme might provide a manager a bonus of $1,000 for every dollar by which the company's stock p
the firms stock?
A call option is not excercised until the stock price exceeds a certain price (exercise price). After it pa
The manager also recieves a bonus proportional to the degree of her success.
Assume a stock has a value of $100. The stock is expected to pay a dividend of $2 per share at year-end. An at-the-money Europ
a 1-year at-the-money European call option on the stock?
S 100
X 100
D 2
P 7
r 0.05
All else equal, is a call option on a stock with a lot of firm-specific risk worth more than one on a stock with little firm-specific
The Value equation for a call equation does not directly relate to the firm specific risk
I would say it is easier to predict the movement of the market because you have more data and less volatility.
If a firm has more risk, then it has a greater probability for reward.
A call option cannot lose more than the amount you spent to purchase it.
So, the upside is GREATER if there is more risk.
We will derive a two-state put option value in this problem. S0 = 100; X = 110; 1+r = 1.10. S can be either 130 or 80.
Question 1: Show that the range of S is 50, whereas that of P is 30 across the two states. What is the hedge ratio of the pu
H - 3/5
Question 2: Form a portfolio of three shares of stock and five puts. What is the (nonrandom) payoff to this portfolio?
S = 80 S = 130
3 shares 240 390
5 Puts 150 0
Discounted 354.54545455
Question 4: Given that the stock is currently selling at 100, solve for the value of the put.
3S + 5P = 300 + 5P
300 + 5P = 354.55
5P = 54.55
P = 10.91
Use the Black-Scholes formula to find the value of a call option on the following stock
d1 0.2192031022
d2 -0.1343502884
C 7.3419869851
N(d1) 0.5867540805
N(d2) 0.4465627946
Find the value of a put option on the stock in Problem 11 with the same exercise price and expiration as the call option.
d1 0.2192031022
d2 -0.1343502884
C 7.3419869851
Recalculate the value of the call option in Problem 11, successively substituting one of the changes below while keeping the oth
Initial Calculation
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0
Time to expiration
Time to expiration 3
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0
Standard deviation
Time to expiration 6
Standard deviation 0.25
Exercise price 50
Stock price 50
Interest rate 0.03
Dividend 0
Exercise price
Time to expiration 6
Standard deviation 0.5
Exercise price 55
Stock price 50
Interest rate 0.03
Dividend 0
Stock price
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 55
Interest rate 0.03
Dividend 0
Interest rate
Time to expiration 6
Standard deviation 0.5
Exercise price 50
Stock price 50
Interest rate 0.05
You would like to be holding a protective put position on the stock XYZ Co. to lock in a guaranteed minimum value of $100 at y
The T-bill rate is 5%. Unfortunately, no put options are traded on XYZ Co.
You would like to be holding a protective put position on the stock XYZ Co. to lock in a guaranteed minimum value of $100 at y
The T-bill rate is 5%. Unfortunately, no put options are traded on XYZ Co.
Question 1: Supposed the desired put option were traded. How much would it cost to purchase?
1+r 1.05
S0 100 Put
uS0 110
dS0 90
X 100
P=
H -0.5
Shares purchased 1
Puts purchased 2
S=90 S=110
1 SHARE 90 110
2 PUTS 20 0
1S + 2P = 100 + 2P
2.380952381
Question 2: What would have been the cost of the protective put portfolio?
1 Share 100
1 Put 2.380952381
SUM 102.38095238
Question 3: What portfolio position in stock and T-bills will ensure you a payoff equal to the payoff that would be provid
Show that the payoff to this portfolio and the cost of establishing the portfolio match those of the desired protective put.
Payoff of Protective Put with X = 100
S = 90 S = 110 2 stocks
PP 100 110 x tbills
110*N + FV = 110
90 * N + FV = 100 Multiply by -1
110*N + FV = 110
N*-90 - FV = -100
Cut out FV
20*N = 10
N = .5
.5 * 90 + FV = 100
45+FV = 100
FV = 55
52.380952381
XYZ Corp. will pay a $2 per share dividend in two months. Its stock price currently is $60 per share. A call option on XYZ has a
stock's volatility (standard deviation) = 7% per month. Find the Black-Scholes value of the option. (Hint: Try defining one "per
Time to expiration 2
Standard deviation 0.07
Exercise price 55
Stock price 60
Interest rate 0.005
Dividend 0
Ch. 20, problem 7
ast month, and you are convinced it is going to break far out of that range in the next three months. You do not know whether it will go up o
ption at an exercise price of $100 is $10.
Use 'EXP()' for 'e' where the exponent goes inside the parentheses.
uture stock price movement, and what price movemenvt is necessary for it to become profitable?
ck price at expiration.
Chart Title
I lose more money if the stock pri
36 38 40 42 44 46
at pay dividends before option expiration. For simplicity, assume that the stock makes one dividendp payment of $D per share at the expira
option?
Value 1 30
Value 2 -20
with the same maturity date as the option and with face value (X+D). What is the value of this portfolio on the option expiration da
stock price.
Buying a Call = S - X
Writing a Call = -1 * (S - X)
80
60
40
20
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 17
-20
-40
-60
-80
-100
a put with exercise price X1, with X2 greater than X1. Graph the payoff to this strategy.
Chart Title
120
100
80
x1
Axis Title
60 x2
s um
40
80
x1
Axis Title
60 x2
s um
40
20
0
0 20 40 60 80 100 120 140 160 180
Axis Title
se price X1, with X2 greater than X1. Graph the payoff to thsis trategy and compare it to Figure 20.10.
Chart Title
80
60
40
20
X1
Axis Title
0 X2
0 20 40 60 80 100 120 140 160 180 SUM
-20
-40
-60
-80
Axis Title
This is a bearish spread, a bullish spread would be reveresed in value such that the payoff is 5 until unti
ollar by which the company's stock price exceeds some cutoff level. In what way is this arrangement equivalent to issuing the manager a cal
price (exercise price). After it passes the cutoff, the holder of the call recieves profit that is proportional to the change in price.
at year-end. An at-the-money European-style put option with one-year maturity sells for $7. If the annual interest rate is 5%, what must be
S - PVx - PVd
e on a stock with little firm-specific risk? The betas of the stocks are equal.
nd less volatility.
ranteed minimum value of $100 at year-end. XYZ currently sells for $100. Over the next year the stock price will increase by 10% or decrea
purchase?
10
er share. A call option on XYZ has an exercise price of $55 and 3-month time to expiration. The risk-free interest rate is 0.5% per month, an
option. (Hint: Try defining one "period"as a month, rather than as a year, andthink about the net-of-dividend value of each share.)
KEY EQUATIONS
t know whether it will go up or down,
se more money if the stock price decreases than if the stock price increases
X1
130 140 150 160 170 X2
X3
SUM
x1
x2
s um
x1
x2
s um
160 180
X1
X2
160 180 SUM
that the payoff is 5 until until the strick price and then it becomes 15