FIN 301 Final Exam, Review Questions
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Final Exam, Review Questions
FIN 301
1. Which of the following is true about a security that plots below the security market line?
A. The security’s return is lower than what it should be based on its risk.
B. The security is under-valued.
C. The security’s return is higher than what it should be based on its risk.
D. A) and B) only.
E. B) and C) only.
2. The benefits from diversification are the greatest when the returns on two assets
A. are independent.
B. are perfectly positively correlated.
C. have a negative correlation coefficient.
D. have a small positive correlation coefficient.
E. have a correlation coefficient of zero.
3. Aurum Inc. is a gold mining firm located in Northern Canada. The correlation between the returns on the market portfolio and Aurum stock is pi,m = 0 (zero). Aurum stock returns have a standard deviation of 
i = 0.35 (i.e. 35%) while the variance of the return on the market portfolio is 
m2 = 0.05. The risk free rate equals Rf = 4.5% and the expected return on the market is E[Rm] = 9.5%.
a) Analysts predict that the price of Aurum stock will increase to $42.5 by the end of the year from its current level of $40 per share. If Aurum pays no dividends, what return can Aurum investors expect based on this forecast?
b) What is the beta of Aurum’s stock? What is the required return on Aurum stock based on its systematic risk? Show/explain your work and comment on your result!
c) Does the expected return calculated in part a) provide adequate compensation for the risk? Is Aurum under- or overvalued (or is it correctly priced)?
4. You look in the newspaper and see the following prices for Mrozek Inc. common stock and American options on Mrozek equity:
Stock price: $60
Price of put option ($70 strike price): $8
Given these prices, what should you do? Is there something wrong here? Explain!
You also see the following entries for American call options on Mrozek Inc. stock:
|
Strike Price |
Expiration |
Price of Call Option |
|
65 |
03/2006 |
$1.50 |
|
65 |
06/2006 |
$1.60 |
|
65 |
09/2006 |
$1.55 |
Is there something wrong here? Explain! (Comment on whether you would be likely to see something like this in practice!)
5. Currently a share of stock in XYZ Inc. sells for $50. Next year it will be worth either $40 or $60. If the risk free rate is 8%, what is the price of a call option with a strike price of $55? What if the possible prices next year are $30 and $70? What general property of option prices does this demonstrate?
6. MyContacts Online Inc. (MCO) stock currently sells for $60 per share. Consider a European put option on MCO stock with a strike price of $66 and time to expiration of six months. This option sells for $9.
a) Draw a payoff diagram for the writer of this option.
b) Suppose April Snow, who does not own any MCO Inc. stock herself, borrows a MyContacts Online stock from another investor and sells it at the current price (i.e. $60).
i. Draw the profit diagram for the short sale described above.
ii. What is April’s opinion: what will happen to MyContacts Online’s stock price over the next six months?
c) Supposed that, at the time she sold MyContacts Online stock short, April also sold the above European put option. Draw the profit diagram for the combined position. Does the profit diagram of the combined position look familiar?
7. Suppose that we are in a world with no taxes or transaction costs. A firm with 500,000 shares outstanding is financed with 50% debt and 50% equity, and – based on their risk – its assets of $10 million are expected to earn a 10% return. Suppose required return on equity is 15% and the cost of debt is 5%, so equity holders expect to receive 15% × 5m = $750,000 a year while bond holders expect to get 5% × 5m = $250,000. Note that each shareholder holds a share worth $10 and expects to receive $1.5 a share per year. (All cash flows are assumed to be perpetual.) Now if you decrease debt financing to 25% and increase equity to 75% by issuing an additional 250,000 shares for $10 each and using the proceeds to retire half of your debt, what will happen to:
a) the expected return on assets; and
b) the expected return on equity? For simplicity, assume that debt is risk free.
8. The market value of a firm with $2,000,000 in debt is $6,800,000. The pre-tax cost of debt for this firm equals 9% (EAR). If the firm were 100% equity financed, the cost of (unlevered) equity would be 14% (EAR). (Assume that both the firm’s cash flows and the debt are perpetual.) Corporate taxes are 40% and interest expenses are tax deductible, while dividends are not. Assume that the agency and bankruptcy costs of debt are zero.
a) What would be the value of the firm if it were financed entirely with equity?
b) Calculate the WACC for the levered firm!
c) How would your answer to a) change if interest expenses were NOT tax deductible?
2023-04-20