Homework answers / question archive / Assignment II Part 1: Question 1: Consider the following returns:   Year End Stock X Realized Return Stock Y Realized Return Stock Z  Realized Return 2004 20

Assignment II Part 1: Question 1: Consider the following returns:   Year End Stock X Realized Return Stock Y Realized Return Stock Z  Realized Return 2004 20

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Assignment II

Part 1:

Question 1:

Consider the following returns:

 

Year End	Stock X Realized Return	Stock Y Realized Return	Stock Z  Realized Return
2004	20.1%	-14.6%	0.2%
2005	72.7%	4.3%	-3.2%
2006	-25.7%	-58.1%	-27.0%
2007	56.9%	71.1%	27.9%
2008	6.7%	17.3%	-5.1%
2009	17.9%	0.9%	-11.3%

Calculate the following:

1. covariance between Stock Y's and Stock Z's returns.
2. correlation between Stock Y's and Stock Z's returns.
3. variance on a portfolio that is made up of equal investments in Stock Y and Stock Z stock.
4. Briefly explain why the covariance of a security with the rest of a well-diversified portfolio is a more appropriate measure of the risk of the security than the security’s variance.
5. If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?
6. Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?

 

 

Question 2:

1. The Faulk Corp. has a 6 percent coupon bond outstanding. The Gonas Company has a 14 percent bond outstanding. Both bonds have 12 years to maturity, make semiannual payments, and have a YTM of 10 percent. If interest rates suddenly rise by 2 percent, what is the percentage change in the price of these bonds? What if interest rates suddenly fall by 2 percent instead? What does this problem tell you about the interest rate risk of lower coupon bonds?
2. Interest rate risk is often explained by using the concept of a teeter-totter. Explain interest rate risk and how it is related to the movements of a teeter-totter.
3. Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case?

1. Short-term interest rates increase unexpectedly.
2. The interest rate a company pays on its short-term debt borrowing is increased by its bank.
3. Oil prices unexpectedly decline.
4. An oil tanker ruptures, creating a large oil spill.
5. A manufacturer loses a multimillion-dollar product liability suit.
6. A Supreme Court decision substantially broadens producer liability for injuries suffered by product users.

 

 

Part 2:

Question 3:

After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread, and must decide whether to make the investment necessary to produce and market it. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to normal freeway usage. The research and development costs so far have totaled about $10 million. The SuperTread would be put on the market beginning this year, and Goodweek expects it to stay on the market for a total of four years. Test marketing costing $5 million has shown that there is a significant market for a SuperTread-type tire.

As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment. Except for the initial investment that will occur immediately, assume all cash flows will occur at year-end.

Goodweek must initially invest $160 million in production equipment to make the SuperTread. This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the SuperTread to two distinct markets:

1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large automobile companies (like General Motors) that buy tires for new cars. In the OEM market, the SuperTread is expected to sell for $41 per tire. The variable cost to produce each tire is $29.
2. The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; Goodweek expects to sell the SuperTread for $62 per tire there. Variable costs are the same as in the OEM market.

Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will also increase at 1 percent above the inflation rate. In addition, the SuperTread project will incur $43 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years.

Goodweek’s corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. The company uses a 13.4 percent discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 6.2 million new cars this year and production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market.

Industry analysts estimate that the replacement tire market size will be 32 million tires this year and that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8 percent market share.

The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule. The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15 percent of sales.

What are the NPV, discounted payback period, and IRR.

 

Question 4:

Ordinary capital budgeting techniques, such as NPV, IRR, and payback period, have pros and cons; nonetheless, many quantitative issues might need a bit of enhancement in these ordinary techniques, such as different lives and different scale projects. Also, the ordinary techniques are governed by solid quantitative analysis and the attempt to enumerate all the decision factors. New investment appraisal techniques tries to overcome this problem and blend the qualitative aspects into capital budgeting decisions.

• Elaborate on two quantitive criteria that deal with the shortcoming of the ordinary capital budgeting techniques related to different lives and different scale projects.
• Also, mention and briefly explain two criteria that mix both quantitive and qualitative factors into capital budgeting decisions.