mtw10key - AP/ADMS 4540 Financial Management Winter 2010...

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1 AP/ADMS 4540 Financial Management Winter 2010 Mid-term Exam Answer Key Instructor: Dr. William Lim Question 1 (20 marks) VANOC, with its cost overruns, wants to obtain a higher return from its assets. Assume that the return on the stock market in any quarter can take one of two possible values: Market Return Probability 11% 0.5 -5% 0.5 Cash returns a riskless 1% per quarter. VANOC decides to outsource its asset management to B-Madoff (BM). BM holds either 100% stock or 100% cash, depending on the stock market forecast. On average, BM holds stocks in 50% of all quarters. 1a. What is the expected rate of return and standard deviation on BM’s portfolio? 1b. What is the expected return on a passive constant-mix portfolio of stocks and cash with the same standard deviation as your answer in part 1a.? What advice would you give VANOC? 1c. Now BM also thinks he can make arbitrage profits. Suppose the following data were collected for a one- factor economy. All portfolios are well diversified. Portfolio E(r) Beta A 12% 1.2 Z 6% 0 Suppose that portfolio B is well diversified with a beta of 0.6 and expected return of 10%. Could you show BM the money, i.e., what trades could BM make to exploit the arbitrage opportunity, if one exists? 1d. Next, the dividends on a certain stock will grow at an annual rate of only 8 percent for the next 6 years and then at an annual rate of 4 percent thereafter. Suppose the return on a market portfolio of stocks is 12 percent, and this stock sells for $15 a share and pays a current dividend of 75 cents. Help BM determine whether this stock is more or less risky than the market portfolio.
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2 Question 2 (15 marks) After fleecing VANOC’s assets, BM is considering opening a restaurant in Toronto selling C$1,000 bottles of vintage wine for $10,000 to G-20 delegates. The restaurant requires renovating an existing office building (owned by BM) by adding new kitchen and dining facilities which cost $250,000, and these facilities have a useful life of 15 years, at which time could be sold for $20,000. The existing office equipment was purchased for $150,000 five years ago and could be sold now for $50,000. In 15 years, the existing office equipment could be sold for $5,000. The new restaurant would boost operating income by $50,000 annually and the facilities have a CCA rate of 25%. BM requires a 15 percent return on his investment, and the corporate tax rate is 43.5 percent. What are the NPV and IRR of opening the restaurant to fleece G-20 delegates? Should BM undertake this investment? We begin calculating the NPV by finding the PV of the increased operating income:
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mtw10key - AP/ADMS 4540 Financial Management Winter 2010...

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