Finance Exam Essay: Q&A

Question 1

Goose Bay Steel (GBS) has a market related βGBS = 1.05 and the company pays a regular dividend of $0.35 quarterly. a) If the risk-free rate is 3% and the market risk premium (return on market above the risk-free rate) is 5%, then what is the required return on GBS’ equity, based on the capital asset pricing model (CAPM). (2 marks) b) What is the value of the company’s stock, if 400,000 shares are outstanding? (2 marks) c) The firm also has 2,500 outstanding bonds with semi-annual coupons paying a coupon rate, CR = 6%. The face value is $1,000, the maturity is in 5 years and these are priced to yield 8%, compounded semi-annually. What is the price of each bond? (3 marks) d) What is the value of the firm? (2 marks) 2. An economy has three possible states: great, not as great, and poor. The returns on the market and two stocks are included in the table below.

Other information in the table can be used as required. Economy (probability) Market Snap Top GREAT (25%) 20% 30% 25% NAG (40%) 10% 7% 10% POOR (35%) -5% -5% 5% E(r) E(rs ) = 8.55% Risk = σ σM = 9.78% σT = 7.81% a) If the covariance between Snap and the market is CovS,M = 124.92 (%)2 , and the correlation between Top and the market is ρT,M = 0.9092, then which stock is more sensitive to changes in the market portfolio? (4 marks) b) What is the expected return of a portfolio invested 1/3 in the market, 1/3 in Snap, and 1/3 in Top? (2 marks) c) If CovS,T = 104.15 (%)2 , what is the risk of this portfolio? (5 marks) d) If you decide to invest 60% of your money in the market and 40% in Treasury Bills (which have a return of 2.5%), what is your expected risk and return? (2 marks) BUSI 4500 – Spring 2018 2 3. Pumpkin π Corporation is an established software development company that has debt and common stock in its capital structure. All questions below deal with the same company:

(a) The 3,000 company bonds (Face Value = 1000) that are still outstanding were issued several years ago and the coupon rate was set at 8% = $40 payment every six months, which was a competitive rate at the time. Since then interest rates have dropped and the bond price has risen to $1070.20. These bonds mature in four years exactly. What is the yield of these bonds? (3 marks) NOTE: You will need access to a spreadsheet or financial calculator for solution.

(b) As part of the Information Technology industry, Pumpkin π has a systematic risk that is above the TSX average: βPπ = 1.50 but the return (rPπ = 17%) is higher than the return on the market. The prevailing risk-free rate, rrf = 4%. What is the return on the market portfolio in this case? (3 marks)

(c) Pumpkin π corporate stock is priced at 20x earnings and there are 200,000 shares outstanding. The Gordon Growth model cannot be used as this high-tech. firm pays no dividend, but it has positive earnings and new communication device called the Pea-Pod is being developed. The return from part b) is a reasonable choice for the discount rate. Research investment this year is $2 million and the production investment next year is $4 million. The cash in-flows in the following four years are $3.5 million, $4 million, $4 million, and $2 million, after which the device will need redesign. What are the company earnings per share this year? (5 marks) (d) What is the total value of Pumpkin π’s equity and what is the value of the firm? (2 marks) Total: 35 marks