A stock is expected to pay the following dividends:
| Cash Flows of a Stock | ||||||
| Time (yrs) | 0 | 1 | 2 | 3 | 4 | ... |
| Dividend ($) | 0.00 | 1.00 | 1.05 | 1.10 | 1.15 | ... |
After year 4, the annual dividend will grow in perpetuity at 5% pa, so;
- the dividend at t=5 will be $1.15(1+0.05),
- the dividend at t=6 will be $1.15(1+0.05)^2, and so on.
The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.
What will be the price of the stock in three and a half years (t = 3.5)?
Question 241 Miller and Modigliani, leverage, payout policy, diversification, NPV
One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage in a world with zero taxes and perfect information since investors can make their own leverage. Therefore corporate capital structure policy is irrelevant since investors can achieve their own desired leverage at the personal level by borrowing or lending on their own.
This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:
(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.
(II) Agency costs: a firm's managers should not try to minimise agency costs.
(III) Diversification: a firm's managers should not try to diversify across industries.
(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.
Which of the above statement(s) are true?
Question 370 capital budgeting, NPV, interest tax shield, WACC, CFFA
| Project Data | ||
| Project life | 2 yrs | |
| Initial investment in equipment | $600k | |
| Depreciation of equipment per year | $250k | |
| Expected sale price of equipment at end of project | $200k | |
| Revenue per job | $12k | |
| Variable cost per job | $4k | |
| Quantity of jobs per year | 120 | |
| Fixed costs per year, paid at the end of each year | $100k | |
| Interest expense in first year (at t=1) | $16.091k | |
| Interest expense in second year (at t=2) | $9.711k | |
| Tax rate | 30% | |
| Government treasury bond yield | 5% | |
| Bank loan debt yield | 6% | |
| Levered cost of equity | 12.5% | |
| Market portfolio return | 10% | |
| Beta of assets | 1.24 | |
| Beta of levered equity | 1.5 | |
| Firm's and project's debt-to-equity ratio | 25% | |
Notes
- The project will require an immediate purchase of $50k of inventory, which will all be sold at cost when the project ends. Current liabilities are negligible so they can be ignored.
Assumptions
- The debt-to-equity ratio will be kept constant throughout the life of the project. The amount of interest expense at the end of each period has been correctly calculated to maintain this constant debt-to-equity ratio. Note that interest expense is different in each year.
- Thousands are represented by 'k' (kilo).
- All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
- All rates and cash flows are nominal. The inflation rate is 2% pa.
- All rates are given as effective annual rates.
- The 50% capital gains tax discount is not available since the project is undertaken by a firm, not an individual.
What is the net present value (NPV) of the project?
One year ago you bought $100,000 of shares partly funded using a margin loan. The margin loan size was $70,000 and the other $30,000 was your own wealth or 'equity' in the share assets.
The interest rate on the margin loan was 7.84% pa.
Over the year, the shares produced a dividend yield of 4% pa and a capital gain of 5% pa.
What was the total return on your wealth? Ignore taxes, assume that all cash flows (interest payments and dividends) were paid and received at the end of the year, and all rates above are effective annual rates.
Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).
High risk firms in danger of bankruptcy tend to have:
Question 708 continuously compounding rate, continuously compounding rate conversion
Convert a 10% continuously compounded annual rate ##(r_\text{cc annual})## into an effective annual rate ##(r_\text{eff annual})##. The equivalent effective annual rate is:
Question 817 expected and historical returns, income and capital returns
Over the last year, a constant-dividend-paying stock's price fell, while it's future expected dividends and profit remained the same. Assume that:
- Now is ##t=0##, last year is ##t=-1## and next year is ##t=1##;
- The dividend is paid at the end of each year, the last dividend was just paid today ##(C_0)## and the next dividend will be paid next year ##(C_1)##;
- Markets are efficient and the dividend discount model is suitable for valuing the stock.
Which of the following statements is NOT correct? The stock's:
Question 834 option, delta, theta, gamma, standard deviation, Black-Scholes-Merton option pricing
Which of the following statements about an option (either a call or put) and its underlying stock is NOT correct?
| European Call Option | ||
| on a non-dividend paying stock | ||
| Description | Symbol | Quantity |
| Spot price ($) | ##S_0## | 20 |
| Strike price ($) | ##K_T## | 18 |
| Risk free cont. comp. rate (pa) | ##r## | 0.05 |
| Standard deviation of the stock's cont. comp. returns (pa) | ##\sigma## | 0.3 |
| Option maturity (years) | ##T## | 1 |
| Call option price ($) | ##c_0## | 3.939488 |
| Delta | ##\Delta = N[d_1]## | 0.747891 |
| ##N[d_2]## | ##N[d_2]## | 0.643514 |
| Gamma | ##\Gamma## | 0.053199 |
| Theta ($/year) | ##\Theta = \partial c / \partial T## | 1.566433 |
Question 956 option, Black-Scholes-Merton option pricing, delta hedging, hedging
A bank sells a European call option on a non-dividend paying stock and delta hedges on a daily basis. Below is the result of their hedging, with columns representing consecutive days. Assume that there are 365 days per year and interest is paid daily in arrears.
| Delta Hedging a Short Call using Stocks and Debt | |||||||
| Description | Symbol | Days to maturity (T in days) | |||||
| 60 | 59 | 58 | 57 | 56 | 55 | ||
| Spot price ($) | S | 10000 | 10125 | 9800 | 9675 | 10000 | 10000 |
| Strike price ($) | K | 10000 | 10000 | 10000 | 10000 | 10000 | 10000 |
| Risk free cont. comp. rate (pa) | r | 0.05 | 0.05 | 0.05 | 0.05 | 0.05 | 0.05 |
| Standard deviation of the stock's cont. comp. returns (pa) | σ | 0.4 | 0.4 | 0.4 | 0.4 | 0.4 | 0.4 |
| Option maturity (years) | T | 0.164384 | 0.161644 | 0.158904 | 0.156164 | 0.153425 | 0.150685 |
| Delta | N[d1] = dc/dS | 0.552416 | 0.582351 | 0.501138 | 0.467885 | 0.550649 | 0.550197 |
| Probability that S > K at maturity in risk neutral world | N[d2] | 0.487871 | 0.51878 | 0.437781 | 0.405685 | 0.488282 | 0.488387 |
| Call option price ($) | c | 685.391158 | 750.26411 | 567.990995 | 501.487157 | 660.982878 | ? |
| Stock investment value ($) | N[d1]*S | 5524.164129 | 5896.301781 | 4911.152036 | 4526.788065 | 5506.488143 | ? |
| Borrowing which partly funds stock investment ($) | N[d2]*K/e^(r*T) | 4838.772971 | 5146.037671 | 4343.161041 | 4025.300909 | 4845.505265 | ? |
| Interest expense from borrowing paid in arrears ($) | r*N[d2]*K/e^(r*T) | 0.662891 | 0.704985 | 0.594994 | 0.551449 | ? | |
| Gain on stock ($) | N[d1]*(SNew - SOld) | 69.052052 | -189.264008 | -62.642245 | 152.062648 | ? | |
| Gain on short call option ($) | -1*(cNew - cOld) | -64.872952 | 182.273114 | 66.503839 | -159.495721 | ? | |
| Net gain ($) | Gains - InterestExpense | 3.516209 | -7.695878 | 3.266599 | -7.984522 | ? | |
| Gamma | Γ = d^2c/dS^2 | 0.000244 | 0.00024 | 0.000255 | 0.00026 | 0.000253 | 0.000255 |
| Theta | θ = dc/dT | 2196.873429 | 2227.881353 | 2182.174706 | 2151.539751 | 2266.589184 | 2285.1895 |
In the last column when there are 55 days left to maturity there are missing values. Which of the following statements about those missing values is NOT correct?