The test will consist of 8-10 short answer/short problems and will focus on the material that we have covered in class and will stress what we have covered after our first test.  Therefore, focus on t

Finance

1. You are evaluating the following bond investments. Both bonds pay $1,000 at maturity. Bond 1 has a three-year maturity, pays a 5% annual coupon, and is A-rated. Bond 1’s yield to maturity is 6%, the 90-day Treasury bill rate is 0.5%, and the 10-year Treasury bond rate is 2.2%. Bond 2 has a five-year maturity, pays an 8% annual coupon, is BB-rated, and the price is reported in today’s Wall Street Journal at 102.

a. What is the yield to maturity of Bond 2?

b. You must identify which bond (Bond 1 or Bond 2) was the greatest interest-rate risk. How can we best identify which of these bonds (Bond 1 or Bond 2) has the greater interest-rate risk? No calculations necessary. Use no more than 25 words.

2. You are contemplating an investment in the stock of Idol Corporation. You know that the price of Idol stock is estimated using the constant-growth dividend discount model and its required return (cost of equity) is estimated using the CAPM.

Yesterday, Idol paid a dividend of $3.00 per share. The dividend is expected to grow at an annual rate of 4% throughout the foreseeable future. Idol’s trailing P/E ratio is 18, its debt/equity ratio is 1.25, and its bonds are rated BB. The yield to maturity (cost of debt) for the bonds of Idol Corporation is 8% (which represents a 500 basis point spread over the risk-free rate). You also know that the expected market return (S&P 500) is 11%, with a standard deviation of 14%. The correlation coefficient between Idol and the market (S&P 500) is .81, the correlation between Idol and the risk-free rate is .49, and Idol’s stock has a standard deviation of 18%.

Calculate the price per share of the Idol Corporation stock.

3. Proctor and Gamble (P&G) is ready to introduce a new detergent. P&G expects the new product to have a 15-year life. Based on all information available as of this morning, it correctly estimated all relevant cashflows for the project. Using the appropriate required return of 11%, P&G estimates that the project’s NPV is $55 million.

We also know that P&G has a beta of 0.43, depreciates all fixed assets using straight-line depreciation (5-year life; no salvage value), has an inventory turnover of 8, a corporate tax rate of 25%, and expects to maintain a net profit margin of 13% throughout the foreseeable future.

Later in the afternoon, the operations manager reports that, due to capacity constraints brought on by the expected growth of sales for the new product, P&G will be required to make new capital expenditures (CAPX) of $100 million at the end of the fifth year of the project’s life. The entire $100 million CAPX will be made at the end of year five. This incremental CAPX was not included in the earlier NPV calculation. The new CAPX will not affect terminal cashflows.

Show whether the new CAPX requirement will affect the project’s desirability.

4. Yesterday, McArnold’s stock paid a dividend of $2.00 per share. The market expects dividend growth of 3% during each of the next two years. After year two, dividends are expected to grow at a constant rate of 2% per year for every year thereafter. The required return for McArnold’s stock is calculated using the capital asset pricing model (CAPM). Your research indicates that McArnold’s stock has a beta of 1 and a payout ratio of 45%. You further know that the 10-year TIPS spread is 1.25%, the risk-free rate is 2%, and the market risk premium is 5%.

a. What is the per share value today of the McArnold’s stock?

b. A report that you receive later today indicates that the beta for McArnold’s stock is expected to decrease. An analyst comments, “Since we know that the returns for the stock market (e.g., the S&P 500) have historically been higher than the returns for most other types of investments, a decrease in the beta for McArnold’s will cause a decrease in its stock price.” Explain why you agree or disagree with the analyst’s comment. Use no more than 50 words.

5. Shortly after its recent bankruptcy, a new incarnation of Sears (to be known as New Sears or “Nears”) is being formed. You have the opportunity to invest in “Nears”. If you invest $200 today, you will receive a zero-coupon bond that will pay $1,000 (face value or principal) at the end of 20 years. To be adequately compensated for the risk of this bond, you know that you should expect a spread (relative to comparable Treasury securities of at least 765 basis points. We also know that that yield for a 90-day Treasury bill is 0.50%, the yield for a 5-year Treasury note is 1.00%, the yield for a 10-year Treasury bond is 1.95%, the yield for a 20-year Treasury bond is 2.35%, and the yield for a 30-year Treasury bond is 3.05%.

A. Provide calculations to identify whether the “Nears” bond appears to be a good investment.

B. How much reinvestment rate risk does this bond have? Explain using less than 25 words.

6. As you prepare for an important interview, you remember an article in today’s Wall Street Journal that reported the results of a survey of CFOs. The CFOs were asked to express opinions regarding expectations of the performance of the overall economy over the next five years. When published this morning at 6:30 AM, the Wall Street Journal reported that the consensus opinion of the CFOs is that overall economic growth will be slower than what the market had previously expected.

a. It is now 8:30 AM and the stock market will open in one hour. Explain how the news from the CFO survey would most likely affect the price of an average stock within the S&P 500. No calculations necessary. Use no more than 25 words.

b. It is now 8:31 AM (59 minutes before the stock market will open). Due to a lack of sleep and an over-abundance of caffeine, you realize that you may have been mistaken about the story in today’s Wall Street Journal. You correctly remembered that the story reports a lower expectation of growth, but incorrectly remembered the source of the expectation. Instead of coming from a survey of CFOs, the lower expectation of growth was expressed by the Chair of the Federal Reserve (Fed) following last night’s meeting of the U.S. Central Bank (Federal Reserve). Would this change your prediction as to how stock prices may react when the stock market opens? Carefully explain. No calculations necessary. Use no more than 25 words.

7. You are the CFO of a major manufacturer, and you are reviewing a report recently completed by a new financial analyst. You note that the analyst used the weighted average cost of capital (WACC) in part of the analysis.

In the report, the analyst had gathered the following inputs:

Dividend yield 0.03 Forward P/E 15

Tax rate 0.25 Trailing P/E 16

Net profit margin 0.10 Debt/equity ratio 0.75

Risk-free rate 0.02 Total asset turnover 5.25

The analyst used the following formula to estimate the firm’s WACC:

WACC = (weight for debt)*(cost of debt) + (weight for equity)*(cost of equity)

0.078 = (0.75)*(0.08) + (0.25)*(.07)

Identify and correct any potential errors in the analyst’s WACC calculation.

8. You are contemplating investments in the stock of Clorox and in the S&P 500 index (a collection of stocks approximately representing the overall market). The Clorox required return (calculated using the capital asset pricing model or CAPM) is 11%, the Clorox beta is .75, and its bonds are rated A. The standard deviation of returns for Clorox stock is 14%. Its payout ratio is 65% and its sales are expected to grow by 7% during the next year. The S&P 500 has a standard deviation of 15%. The A-rated bond yield is 5.1% and the expected return of risk-free securities is 3%.

a. Calculate the standard deviation of a portfolio consisting of 30% invested in Clorox stock and 70% invested in the S&P 500.

b. Your research indicates that Clorox is becoming less highly correlated with the overall stock market (i.e., the S&P 500). Calculate the required return for Clorox if its correlation with the market decreased to 0.68.