Additional practice questions with solutions

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Monash University **We aren't endorsed by this school
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BANKING AN BFF2140
Subject
Finance
Date
Oct 21, 2023
Pages
14
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BFF2140 S1 2023 Additional practice questions-SOLUTIONS Note that this document's structure is not reflective of the current exam structure. These additional questions are provided purely for further practice. Refer back to the "Practice questions for final exam" document in Moodle to familiarise yourself with the current exam's structure (paying attention to the way answers will have to be input in the final exam). It is recommended you attempt the questions below after reviewing tutorials and lectures, and first attempting the abovementioned "Practice questions for final exam". Capital Budgeting and Short-Term Financing Which of the following is a reason why incremental earnings may be different from incremental cash flows? A. Changes in accounts receivable reflects non-cash sales present in incremental earnings that are not in incremental cash flows. B. Depreciation is a cash expense, but does not appear in incremental earnings. C. Capital expenditures appear on the income statement. However, as these costs are depreciated over time, they should not be present in incremental cash flows. D. Firms pay taxes based on incremental cash flows, not incremental earnings. ANSWER: A Combining learning from Lecture 5 (capital budgeting) and Lecture 7 (NWC management) Risk and Return + Diversification a) Alpaca Company just paid a dividend of $0.70 a share. The current share price is $17.80 and the share price six months ago was $17.60. Calculate the holding period return on Alpaca Company over this six-month period. R = (17.80-17.60 + 0.70)/17.60 = 0.051136 R=5.11% per six months HPR= [(P1-P0)+CF]/P0
b) Bandicoot Company has the following probability distribution of returns: (i) Calculate the expected return of Bandicoot Company E(R) = [ 0.2 *(-0.05)] + ( 0.3 *0) + ( 0.3 *0.05) + ( 0.2 *0.1) = 0.025 = 2.5% (ii) Calculate the variance of Bandicoot Company variance = 0.2 (-0.05 - 0.025 ) 2 + 0.3 (0 - 0.025 ) 2 + 0.3 (0.05 - 0.025 ) 2 + 0.2 (0.1 - 0.025 ) 2 = 0.002625 (recall: variance is movement away from the mean squared, applying probability to each possible occurrence: there is a 20% chance that the return of -0.05 will vary from the mean of 0.025 squared, 30% chance that the return of 0 will vary from the mean of 0.025 squared and so on) (iii) Calculate the coefficient of variation of Bandicoot Company std dev = √(0.002625) = 0.051235 CV =std dev/mean return= 0.051235/0.025 = 2.05 (iv) If Alpaca Company has a CV of 1.75 which of the companies-Bandicoot or Alpaca would you choose as a risk averse investor? Choose Alpaca as it has a lower CV which implies lower risk for each unit of return (v) If the correlation coefficient between Bandicoot and Alpaca is 0.9787, would these two shares (Bandicoot and Alpaca) offer good diversification? Why or why not? No, 0.9787 is very close to 1 which is perfect positive correlation, hence very little diversification is possible. (However, recall that as long as correlation is less than 1, there is still possibility for diversification. In this case, it is just very little diversification being possible, so not a good choice for diversification purposes). Portfolio Theory The table below presents the expected returns, betas and standard deviations for three assets A, B and C. The expected return on the market is 14% and the risk-free return is 3%. Asset E(R) Beta Std deviation A 8% 0.8 6% B 10.5% 1.2 8% C 23% 1.6 12%
a) What can you say about the systematic risk of each of the three assets relative to the systematic risk of the market? A has less systematic risk than the market whereas B and C have more systematic risk than the market. (Recall: Beta of market=1) b) What is the beta of a portfolio comprised of 20% in A, 30% in B, and 50% in C? Beta = 0.2(0.8) + 0.3(1.2) + 0.5(1.6) = 1.32 c) Are the assets under- or over-priced according to the CAPM? E(R A ) = 0.03 + 0.8(0.14 - 0.03) = 0.118 = 11.8% E(R B ) = 0.03 + 1.2(0.14 - 0.03) = 0.162 = 16.2% E(R C ) = 0.03 + 1.6(0.14 - 0.03) = 0.206 = 20.6% A's given expected return of 8% is less than that suggested by the CAPM (11.8%) meaning it is plotting below the SML (achieving a return lower than that its beta dictates according to the CAPM)=so A is overpriced. (recall that the SML is the graphical representation of the CAPM formula and that the E(R) generated using the CAPM formula plot ON the SML). B's given expected return of 10.5% is less than that suggested by the CAPM (16.2%) meaning it is plotting below the SML so B is also overpriced. C's given expected return of 23% is more than that suggested by the CAPM (20.6%) meaning it is plotting above the SML so C is underpriced. d) According to the Sharpe ratio, which asset is superior? SharpeA = (0.08 - 0.03)/0.06 = 0.83333 SharpeB = (0.105 - 0.03)/0.08 = 0.9375 SharpeC = (0.23 - 0.03)/0.12 = 1.66667 Asset C is superior as it has the highest Sharpe ratio Cost of Capital Comfyshoes is an all equity firm that has a current share price of $63, a beta of 1.1 and has just paid a dividend of $5.50 per share. Analysts expect Comfyshoes ' dividends to grow by 3% p.a. The market risk premium is 6.5% p.a. and the risk-free rate is 3.5% p.a. a) Calculate the cost of equity of Comfyshoes using two different approaches.
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