Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: daixieit 

Final Examination  

FOUNDATIONS OF FINANCE

Question 1 (4 marks)

Your friend Tom has just spent a successful day betting at the Melbourne Cup, winning $10,000 for his efforts.  Tom has decided to invest his winnings in a term deposit account for 6 months, after which he will use the funds to purchase a second-hand car.  Obviously, Tom wants to invest his money in the investment which pays the highest interest, so he has collected information on the term deposits offered by various banks and is trying to compare them.  Unfortunately, he doesn’t know how to convert interest rates so has asked you to take the three interest rate quotations below and convert them into 6-monthly periodic rates.  Using the figures you have calculated, tell Tom which investment he should choose (i.e. investment a), b), or c)) and why:

a) 5% p.a. compounded six-monthly;

b) 4.5% p.a. compounded daily;

c) 4.75% p.a. compounded quarterly.  

Question 2 (6 marks)

Steve and Jenny have a newborn baby named Charlotte.  When Charlotte was born, her grandparents gave Steve and Jenny $10,000 to be spent on their new granddaughter.  After discussions, Steve and Jenny have decided to invest this gift in trust for Charlotte so that on her 21st birthday she will have a deposit to buy a one bedroom unit.  Steve and Jenny are also considering making additional annual payments to the trust account in order to increase the deposit amount to 40% of the expected price of the unit.

Assuming that the current price of a one bedroom home unit is $200,000, property prices grow at 3% pa. and the trust receives interest at 8% pa., answer the following questions (NB: In answering these questions, assume that both the growth and interest rates above are compounded annually):

a) What is the projected amount that will be available to Charlotte, when she turns 21, from the gift that is being held in trust? (1 marks)

b) How much must Steve and Jenny contribute per annum to achieve the desired deposit amount of 40% of the unit’s expected purchase price?  (5 marks)

Question 3 (10 marks)

You work as a financial advisor for STOCKWIZ Limited and specialise in constructing share portfolios for investors.  You have just been given the following information on two stocks:

Additionally, you have been told that the correlation between these two stocks is 0.20.  Given this information, you are asked to calculate the following figures for a client who is interested in investing in a portfolio comprising only these two stocks:

a) What weights would you need to hold of ABC and BHP shares in order to obtain an expected return of 8% on your portfolio? (2 marks)

b) What is the standard deviation of the portfolio comprising ABC and BHP in the weights calculated in a)? (3 marks)

c) What are the minimum variance portfolio weights for a portfolio comprising ABC and BHP?(2 marks)

d) Briefly outline the benefits of diversification.  In providing an answer, make sure you discuss how diversification benefits are maximised.  (3 marks)

Question 4 (5 marks)

Recall that, earlier in the year, you were considering investing your hard earned money in a company called VC Limited.  In deciding whether to make this investment, you employed a Dividend Discount Model with constant growth to calculate the value to you of one share in the company.  Knowing that the company pays annual dividends and that last dividend, just paid, was 50c, you used a required rate of return of 10% p.a. and a constant dividend growth rate of 4.5% p.a. to arrive at a theoretical value of $9.50 per share.  However, the 10% required rate of return figure was one your friend suggested you use and, since then, you have learnt ways you can estimate this figure yourself.  In light of this, you have decided to reconsider investing in VC Limited and have estimated the following:

· Standard deviation of shares in VC Limited is 6.25% p.a.;

· Standard deviation of the market is 5% p.a.; and,

· Correlation between shares in VC Limited and the market is 0.40.

· The risk-free rate of return is 6% p.a.; and,

· The market risk premium is 8% p.a.

Using a Dividend Discount Model with a constant dividend growth rate of 4.5% p.a. and the required rate of return you calculate, what is the theoretical value to you of one share in VC Limited?  If shares in the company are still trading at $10.00, do they represent a good investment from your perspective?

Question 5 (8 marks)

Nut Roast Limited, producers of fine quality scorched almonds, is considering introducing a new line of chilled drinks.  However, despite careful consideration, the company has been unable to decide whether they should undertake a project that would see them produce freshly squeezed juice or whether the production of ginger ale is more viable.  Unable to make the final decision between these 2 investment opportunities, the company has contacted you, their trusted financial advisor, and asked you whether you could indicate which project, if any, would be the better choice.  In asking your advice, the company has told you that the machinery in both projects will have a salvage value of $10,000 at the end of their useful life and would be depreciated straight line over their entire useful life.  Details of each project’s cash flows are tabulated below:

In addition to cash flow information, you have also been provided with the following details:

· Both investment opportunities are in a different industry to the firm’s normal operations;

· The industry in which both investment opportunities are available is considered 30% more risky than the firm’s industry;

· The firm’s beta is 1.5;

· The risk-free rate is 5% p.a;

· The expected return on the market is 10% p.a; and,

· The tax rate is 30%.

Given this information, which project, if any, do you recommend Nut Roast Limited proceed with?  What is your reasoning behind making your recommendation?

Question 6 (12 marks)

Students are to answer ALL parts of this question:

a) You are an arbitrageur with a keen interest in the soft commodities markets and observe that, at present, the spot price of a bushel of wheat is 550 cents.  Given that the risk free rate and the cost of carry are 5% p.a. and 3% p.a. respectively and the price of a wheat futures contract with 6 months to expiry is 575 cents per bushel, answer the following questions:

i) Is there an arbitrage opportunity present in this market?  If so, what strategy could you execute to earn a riskless arbitrage profit?  How much profit would you earn per bushel of wheat if you executed this strategy?    (5 marks)

ii) Suppose you find an arbitrage opportunity in a).  As such an opportunity necessarily requires a zero net investment and generates a risk-free profit, it is obviously a very attractive trading strategy. Explain what, if anything, stops you from simply repeating the arbitrage transactions over and over again and thereby earning unlimited risk-free profits. (2 marks)

iii) Are there any reasons why any arbitrage opportunities present could persist in a market? (1 marks)

b) Outline the key similarities and differences between futures and forward contracts (4 marks)

Question 7 (15 marks)

Students are to answer ALL parts of this question:

a) You have just been employed by a risk management firm called Risk Busters, where your primary job is to explain the benefits of using derivatives to clients.  One client you are helping at present understands what futures and forwards contracts are, but is having difficulties grasping what options are and how they reduce risk.  To help clear up their confusion, do the following:

i) Discuss the differences between futures / forward contracts and options.  (3 marks) 

ii) Describe the differences between a short position in an American call option and a long position in a European put option.  (3 marks)

iii) Draw the payoff and profit diagrams for a short position in a European put option.  Make sure you clearly label both diagrams.  (4 marks)

b) Suppose European call and put options on Boral are selling for $0.20 and $0.10 respectively. Both options are struck at $3.50 and mature in three months. The current stock price is $3.61 and the risk free rate is 5.2% p.a. Is there an arbitrage opportunity in this market?  Indicate what strategy you would implement in taking advantage of any arbitrage opportunity and the profit you would earn from your strategy (Note: You are NOT required to provide a table outlining the initial and terminal values of your strategy)  (5 marks)