Assessment Exam #2: Review Problems BM410: Investments Assessment Exam #2: Review Problems

Preparing for the 2nd Assessment Exam How to do well on my exams (by order of what I think is most important): 1. Review the PowerPoints for each class These are the things I consider important Especially look for application problems and know how to do them 2. Review the previous quizzes and exams Check your answers from the net 3. Review the homework problems and readings Think through the purpose for each problem

Problem 1: Economic Analysis What monetary and fiscal policies might be prescribed for an economy in a deep recession?

Answer Expansionary (i.e., looser) monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.

Problem 2: Industry Analysis In which stage of the industry life cycle would you place the following industries. Note that there is often considerable room for disagreement concerning the “correct” answers to this question (use start-up, consolidation, maturity, and decline as your major stages). A. Oil well equipment B. Computer hardware C. computer software D. Genetic engineering E. Railroads

Answer a. Oil well equipment. Possible decline worldwide, due to environmental pressures and a decline in easily-developed oil fields, but may be in maturity in the US due to increased need for energy b. Computer hardware Generally a consolidation or maturity stage c. Computer software Likely in a consolidation stage currently d. Genetic engineering Likely in a start-up stage e. Railroads Likely in Relative decline

Problem 3: Equity Valuation A common stock pays an annual dividend per share of $2.10. The risk-free rate is 7% and the risk premium for this stock is 4%. If the annual dividend is expected to remain at $2.10, what is the value of the stock?

Answer If the risk premium on the stock is 4%, and the risk-free rate is 7%, then the require rate on the stock would be 11%. Given a forecast dividend of $2.10, divide that by your 11% discount rate to give a price of = $19.09

Problem 4: Financial Statement Analysis An analyst applies the DuPont system of financial analysis to the following data for a company: Leverage ratio 2.2 Total Asset turnover 2.0 Net Profit Margin 5.5% Dividend payout ratio 31.8% What is the company’s return on equity?

Answer The goal is to get earnings over equity. Leverage is Assets/Equity Asset turnover is Sales/Assets Profit Margin is Earnings/Sales Payout ratio is Dividends/Earnings If we take: Earnings/S * S/A * A/Equity, the Sales and Assets cancel to give Earnings over Equity. Numerically, it is: 5.5%  2.0  2.2 = 24.2%

Problem 5: Taxes You are choosing a fund that you will put in your investment (non-retirement) account. Assuming distribution and operating activities which occurred in the past will likely continue, which of the following funds should you include in your taxable (non-retirement) account. Assume federal taxes on short term distributions are 35% and state taxes are 7%. How would this change if these were both stock funds? Mutual Funds Fund A Fund B Beginning NAV $10.00 $10.00 YTD Nominal returns 10% 10% Estimated Turnover 10% 90% Short-term distributions .10 .90 Ending NAV 10.90 10.10

Answer Mutual Funds Fund A Fund B Beginning NAV $10.00 $10.00 Short-term distributions .10 .90 Ending NAV 10.90 10.10 Tax on ST distributions 35%+7% 35%+7% Taxes paid (w/o selling) .042 .378 After-tax return 9.58% 6.22% Loss from return due to taxes .42% 3.78% Although both have the same before-tax return, fund B had a 35% lower return due to taxes. Fund A is the better choice for a taxable account, while either fund could be used for a retirement account

Problem 6: Stock Performance Last year you purchased 100 shares of MAM Corporation for $40 per share. Over the past 12 months MAM’s share price has gone up to $45 per share, and you received a dividend of $1 per share. What was your total rate of return on your investment in MAM stock?

Answer You can do this problem two ways. First, total payout. (($4,500-$4,000) + 100) / $4,000 = ? 15% Or, share amount ($45 – 40) + 1 / 40 = ?

Problem 7: Stock Performance Your investment in MAM stock was so successful that you decided to hold it for 5 more years. Remember, you purchased 100 shares for $40 per share. Unfortunately, the price of MAM stock has not risen; it is back to where you purchased it. The good news is that you earned $1 per share for five years. Calculate your annualized total rate of return. Compared to a bank account earning 2% APY, how did your stock do?

Answer The easy way: $1/$40 = 2.50% Or [1+(($4,000-$4,000) + 500) / $4,000)](1/5) = 2.38% The stock performed better than the bank account

Problem 8: Retirement Planning Andrew and Suzy recently reviewed their future retirement income and expense projection. They hope to retire in 30 years. They determined that they would need an annual retirement income of $80,000 in today’s dollars, but they currently only have $25,000 annually with expected Social Security and savings. Calculate the total amount that Andrew and Suzy must save for retirement if they wish to meet their income projection, assuming a 3% inflation rate before retirement and 2% after, and an 8% return before retirement and 6% after retirement. They believe they will be in retirement for 25 years.

Answer First, draw the diagram 1. Calculate the Shortfall 2. Inflation adjust the shortfall 3. Calculate the real return and the annuity 4. Calculate the period payment Time 30 years 25 years Return 8% Return 6% Inflation 3% Inflation 2% Now Retirement Death

Answer 1. The annual shortfall is: 80,000 – 25,000 = ? The shortfall is $55,000. 2. To get the inflation adjusted amount, we use: PV = -55,000, I/Y = 3, N = 30, and solve for FV which gives the amount that they need annually in retirement. FV of $133,499

Answer 3. To get the real return and the annuity for 25 years, calculate the real return with 6% nominal and 2% inflation, which gives a real return of ? Real return of 3.92% = [(1.06)/(1.02)] – 1. The annuity required is PMT = $133,499, I = 3.92, N = 25, PV = ? The annuity needed is $2,103,279 4. to get the amount to save, it is I = 8%, N = 30, FV = $2,103,279, and PMT = ? To give what you need to save each year They need to save $18,567 to reach their goals t your individual level of savings or your current financial condition.

Problem 9: International Investing If the current exchange rate is $1.75/£, the one-year forward exchange rate is $1.85/£, and the interest rate on British government bills is 8% per year, what risk-free dollar-denominated return can be lock in by investing in the British bills?

Answer The formula is: (1 + r(US)) = (1 + r(UK))  (F0/E0). (F0/E0) is just 1 + the return from the currency. To get the US return, solve for: = 1.08 * (1.85/1.75) = 1.1417 - 1 = 14.17% F0 is the forward rate. E0 is the exchange rate