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Final Examination 

FOUNDATIONS OF FINANCE

Question 1

Students are to answer ALL parts of this question:

a) Find the price of a 9%, $100 Commonwealth Government bond with exactly 6 and one quarter years to maturity given a required rate of return of 6% p.a.

b) What are the four major types of corporate bonds?  Be sure to provide a brief description of each one.

Question 2

Students are to answer ALL parts of this question:

After successfully completing Foundations of Finance, you have decided to start your own investment portfolio.  Although you know you should invest in many different companies to take advantage of the benefits of diversification, you have insufficient funds.  As such, you have decided to invest your money in David Jones and Rio Tinto.  The table below details some information for both stocks:

Additionally, you know that the correlation between these two stocks is 1.  Given this information, calculate the following:

a) What weights would you need to hold of David Jones and Rio Tinto shares in order to obtain an expected return of 11.25% on your portfolio?

b) What is the standard deviation of the portfolio comprising David Jones and Rio Tinto in the weights calculated in a)?

c) What are the minimum variance portfolio weights for a portfolio comprising David Jones and Rio Tinto?  Discuss the meanings of the weights you have calculated.

Question 3

Plasma Ltd, makers of plasma televisions, is considering also making DVD players.  They have the choice of two machines with which to make the DVD players, and both could do the job adequately.  They have called upon you to assist them in deciding whether Machine A or Machine B should be purchased.  Both machines are to be depreciated straight line down to a book value of zero over their entire useful life.  Despite this, it is anticipated that Machine A will be sold for $8,000 and Machine B for $12,000 at the end of their useful lives.  Details of each project’s cash flows are tabulated below:

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

· The corporate tax rate is 30%;

· Tax is payable annually in arrears (ie tax is paid on profits one year after it is earned);

· The project is in an industry which is 15% less risky than the industry in which the firm currently operates;

· Plasma Ltd currently has a beta of 1.7;

· The market risk premium is 10% p.a.; and,

· The expected return on the market is 18% p.a.

Given this information, which machine, if any, do you recommend Plasma Ltd purchase?  In providing your answer, explain why you have made your recommendation.

Question 4

Students are to answer ALL parts of this question:

a) Calculate the required rate of return for a risky asset whose correlation with the market is 0.85, given the standard deviation of the asset is 8% p.a., the standard deviation of the market is 11% p.a., the expected return on the market is 9% p.a. and the risk free rate is 5% p.a.

b) Draw the graphical depiction of the relationship described by the Capital Asset Pricing Model.  Be sure to clearly label the diagram.

c) In a large portfolio, what is the appropriate measure of risk for an individual asset?  Why is this so?

Question 5

Students are to answer ALL parts of this question:

a) Draw payoff diagrams for a long position in a forward contract and a short position in a futures contract.  Be sure to clearly label both diagrams.

b) Draw the profit diagrams for a long position in a European put option, and a short position in a European call option.  Be sure to clearly label both diagrams.

c) You have the following information regarding European options written on Telstra.  Using this information, discuss whether put-call parity holds in this instance?  If it doesn’t, indicate what strategy you would implement on taking advantage of any arbitrage opportunity and the profit you would earn from your strategy (Note: You are required to provide a table outlining the initial and terminal values of your strategy).

· A Telstra share is currently selling for $9 in the market place.

· A 10-month European call option contract on Telstra with a strike price of $8 is priced at $2.

· A 10-month European put option contract on Telstra with a strike price of $8 is priced at $1.50.

· The risk-free rate of interest is 8% p.a. compounded quarterly.

d) Suppose an American put option on Coles Myer stock struck at $9.00 is currently selling for $0.50, and the current stock price is $8.35.  How can a straightforward arbitrage be executed?  How would you answer change if it were a European put option with exactly the same cost and strike price?

Question 6

Students are to answer ALL parts of this question:

You are the Chief Financial Officer for a major Australian mining company called ABC Mining.  As a result of the booming commodity prices over the last year, your company is expecting to have a surplus of almost $20 million cash on hand at the end of September.  The Board of Directors of ABC Mining wants you to invest the cash for a period of 90 days.  The September 90-day BAB futures contract is currently trading at 92.  Given this information, answer all three of the following questions:  

a) Advise the Board of ABC Mining how they can lock in an interest rate, and show that the strategy works if interest rates rise or fall.

b) How could ABC Mining take advantage of any favourable movements in interest rates, while insuring that they are protected against adverse movements?  Again, be sure to show that strategy works if interest rates rise or fall.

c) Detail any advantages or disadvantages from using the strategy you have devised in part b) as compared with part a).