Capital Markets Practice Midterm 3

Question 1 (45 points)

You are advising a client on her fixed income portfolio. The client's portfolio is worth $2,000,000.

•   Currently the portfolio has $700,000 invested in 3-year 5.5% coupon bonds and   $1,300,000 invested in a long-term bond fund which has a duration of 12.4 years.

•   The yield curve is currently flat at 4.5% per year.

•   Assume face values of $1,000.

•   Assume coupons are paid once a year.

a)  What is the duration of the 3-year 5.5% coupon bond?

b)  What is the duration of your client's portfolio?

c)  Your client is worried that the yield curve may shift up. You consider a scenario where the yield curve shifts up by 0.5%. What dollar amount (approximately) would your client lose in that case?

d)  Suppose the client does not want to lose more than $40,000 in this yield curve scenario. You advise her that she will need to change her portfolio weights. What dollar investments in the 3-year 5.5% coupon bonds and the long-term bond fund would imply a $40,000 loss in this yield curve scenario?

Question 2 (40 points)

Use Portfolio Visualizer to answer the following questions. When using Portfolio Visualizer’s Historical Efficient Frontier optimization, set the “End Year” to 2021.

You are the financial advisor to Adaugo.

•   You have given Adaugo a questionnaire to elicit her attitudes towards risk. Based on the questionnaire you have determined that the best risk level for Adaugo is a standard deviation of 16.75% for her overall portfolio.

•   You recommend Adaugo invest in the following four mutual funds in her 401(k) account.

1 MINDX: Matthews India Investor Mutual Fund

1 OBCHX: Oberweis China Opportunities Mutual Fund

1 DBEU: Xtrackers MSCI Europe Hedge Equity ETF

1 SLVAX: Columbia Select Large Cap Value Mutual Fund

Using these four funds and assuming a risk-free return of 0.70%, what portfolio do you recommend Adaugo invest in? The portfolio you recommend must be feasible for Adaugo to invest in via her 401(k) account.

a)  What are your recommended portfolio weights across all investments, including the risk-free asset?

b)  What are the expected return, standard deviation, and Sharpe ratio for your recommended portfolio?

c)  Explain how you determined Adaugo’s portfolio weights and why you selected your recommended portfolio over others.

Question 3 (40 points)

In this exam’s Excel file’s Q3 worksheet, you will find forecasted financial data for

company XYZ. Using these forecasts, answer the following questions.

Assume that XYZ’s tax rate is 21%.

a)  What are firm XYZ’s free cash flows for years 1-6?

b)  If XYZ has a CAPM equity beta of 2.4, a debt beta of 0.15, a debt/value ratio of 51%, the risk-free return is 0.5%, and the market risk premium is 6%, what is XYZ’s firm discount rate?

c)  Given (1) and (2) what is XYZ’s discounted cash flow stock market capitalization? Assume a terminal growth rate of 3%. Assume you are valuing XYZ on the last day of year 0.