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BİLGİ UNIVERSITY, INSURANCE AND INVESTMENT - BUS 431-01
FINAL EXAMINATION, 09 February 2002
INSTRUCTOR:BÜLENT ŞENVER
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Duration: 2.5 Hours. Answer All Questions. You may use your calculator.
Q(1) (24 Marks) Valuation of Common Stock
The Constant Growth Corporation (CGC) has expected earnings per share (E1) of $5. It has a history of paying cash dividends equal to 20% of earnings. The market capitalization rate for CGC’s stock is 15% per year and the expected ROE on the firm’s future investments is 17% per year. Using the constant growth rate discounted dividend model,
a)What is the expected growth rate of dividends? (4marks)
b)What is the model’s estimate of the present value of the stock? (4marks)
c)If the model is right, what is the expected price of a share a year from now? (4marks)
d)Suppose that the current price of a share is $50.
By how much would you have to adjust each of the following model parameters to “justify” this observed price:
- The expected ROE on the firm’s future investments. (4marks)
- The market capitalization rate. (4marks)
- The dividend payout ratio. (4marks)
Q(2) (06 Marks) Real Interest Rate Parity
Assume that the world-wide risk-free real rate of interest is 3% per year. Inflation in Switzerland is 2% per year and in the United States it is 5% per year. Assuming there is no uncertainty about inflation, what are the implied nominal interest rates denominated in Swiss francs and in US dollars?
Q(3) (12 Marks) Bond Valuation With a Non-Term Structure
Suppose you observe the following prices for zero-coupon bonds (pure discount bonds) that have no risk of default.
Maturity / Price per $1 of Face Value / Yield to Maturity1 year / 0.97 / 3.093%
2 years / 0.90 / ?
- What should be the price of a 2-year coupon bond that pays a 6% coupon rate, assuming coupon payments are made once a year starting one year from now? (4marks)
- Find the missing entry in the table. (4marks)
- What should be the yield to maturity of the 2-year coupon bond in part a ? (4marks)
Q(4) (20 Marks) Risk Management Process and Techniques
The risk-management process is a systematic attempt to analyze and deal with risk. This process can be broken down into 5 steps.
- Explain the 5 steps mentioned above.(10 marks)
- There are 4 basic techniques available for reducing risk. Explain these 4 basic techniques. (10 marks)
Q(5) (23 Marks) Implications of Capital Asset Pricing Model (CAPM)
The riskless rate of interest is 0.06 per year, and the expected rate of return on the market portfolio is 0.15 per year.
- According to the CAPM, what is the efficient way for an investor to achieve an expected rate of return of 0.10 per year? (5 marks)
- If the standard deviation of the rate of return on the market portfolio is 0.20, what is the standard deviation on the above portfolio? (5 marks)
- Draw the CML and locate the foregoing portfolio on the same graph. (4 marks)
- Draw the SML and locate the foregoing portfolio on the same graph. (4 marks)
- Estimate the value of stock with an expected dividend per share of $5 this coming year, an expected dividend growth rate of 4% per year forever, and a beta of 0.8 . If its market price is less than the value you have estimated, i.e., if it is under-priced, what is true of its mean rate of return? (5 marks)
Q(6) (15 Marks) Forward-Spot Parity Relation with Known Cash Payouts
Suppose that the Treasury yield curve is flat at an interest rate of 7% per year (compounded semiannually).
- What is the spot price of a 30-year Treasury bond with an 8% coupon rate assuming coupons are paid semiannually? (4 marks)
- What is the forward price of the bond for delivery six months from now? (4 marks)
- Show that if the forward price is $1 lower than in your answer to part b, there should be an arbitrage opportunity. Complete the below table.( 7marks)
Arbitrage Position / Immediate Cash Flow / Cash Flow 1 year from Now
Sell......
Buy......
Buy......
Net Cash Flows
1