Financial Management Principles (FINA 3311)

Financial Management Principles (FINA 3311)

Exam II, Spring 2019-20

Total Points: 30 (8×3+1×2+1×4)

Today: April 8, 2020; Due Date:

It is an individual work. No copying. Must be hand-written, scanned and submitted by email attachment.

  1. Define systematic (market) and unsystematic (unique) risk. Give two examples for each of them. Which one is more important and why?
  • Systematic risk is a type of risk that cannot be diversified away in which it is associated with the entire market. Examples: inflation, changes in interest rates.
  • Unsystematic risk is a type of risk that can be reduced through diversification in which it is associated with a specific industry. Examples: management risk and location risk.
  • Systematic risk is more important because it may affect the entire market moreover, the risk is spread from unhealthy institutions to the healthy ones.
  1. Suppose for a project, initial investment is $13,000. The cash flows for next 4 years are $2,000, $4,000, $6,000 and $9,000. Calculate the net present value (NPV) and IRR of this project. Should you accept the project?

Suppose the interest rate is 8%.

CF0= -13000

CF1=2000

CF2=4000

CF3=6000

CF4=9000

I=8

NPV= 3,659.46

IRR=17.56%

Yes, we should accept the project.

  1. Suppose the Treasury bond rate is 5%, the average return on the S&P 500 index is 12%, and XYZ, Inc. has a beta of 1.5. According to the CAPM, what should be the required rate of return on XYZ stock?

Equation slide 58, chapter 7&8.

Kj= 0.05 + 1.5 (.12 – 0.05) = 0.155 = 15.5%

  1. Use the following information to find volatility (standard deviation) and expected return of ABC Company. Also find coefficient of variation. How do you explain? Which stock is riskier considering both risk and return? 4 Points

States          Probability                         Return             

Economy         (P)                  Orl. Utility     Orl. Tech

Recession       0.20                    4%            -10%

Bad                 0.10                   6%              4%

Normal            0.40                  10%            14%

Boom               0.30                  14%            30%

Expected return:

K(ou)= 0.20(4%)+0.10(6%)+0.40(10%)+0.30(14%) = 9.6%

K(OI)= 0.20(-10%)+0.10(4%)+0.40(14%)+0.30(30%) = 13%

Standard deviation:

6.272

1.296

6.4

5.808

19.776 = 4.45%

0.01058

8.1

4

8.67

20.78058 = 4.56%

Coefficient of variation

46.35%

35.07%

  1. You bought a bond for $1,100. It has a face value of $1,000 and will mature in 8 years. It gives semi-annual coupon of 10%. Calculate the YTM of this company.

PMT = 10% / 2 = 5

FV= 1000

N= 8×2 = 16

PV=1100

  1. QQ Corp. gives dividend of $6 just few days ago. You believe that the dividend amount will grow at 4%. This firm’s stock is now selling for $80. What is the cost of capital (discount rate) of QQ Corp’s stock?
  1. A firm’s preferred stock is selling for $1,100. Preferred dividend is fixed at $8.5. What is the cost of preferred capital? 2 points
  1. Write down the CAPM equation. Correctly explain the notations used in the equation.
  1. Why are we NOT able to diversify market risk?
  1. Explain the difference between required return and expected return. Give an example for both of them.

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