**Question 575** inflation, real and nominal returns and cash flows

You expect a **nominal** payment of $100 in 5 years. The **real** discount rate is 10% pa and the inflation rate is 3% pa. Which of the following statements is **NOT** correct?

**Question 578** inflation, real and nominal returns and cash flows

Which of the following statements about inflation is **NOT** correct?

A student won $**1**m in a lottery. Currently the money is in a bank account which pays interest at **6**% pa, given as an APR compounding per month.

She plans to spend $**20,000** at the **beginning** of every month from now on (so the first withdrawal will be at t=0). After each withdrawal, she will check how much money is left in the account. When there is less than $**500,000** left, she will donate that remaining amount to charity.

In how many months will she make her last withdrawal and donate the remainder to charity?

An investor owns a whole level of an old office building which is currently worth $1 million. There are three mutually exclusive projects that can be started by the investor. The office building level can be:

- Rented out to a tenant for one year at $0.1m paid immediately, and then sold for $0.99m in one year.
- Refurbished into more modern commercial office rooms at a cost of $1m now, and then sold for $2.3m when the refurbishment is finished in one year.
- Converted into residential apartments at a cost of $2m now, and then sold for $3.4m when the conversion is finished in one year.

All of the development projects have the same risk so the required return of each is **10**% pa. The table below shows the estimated cash flows and internal rates of returns (IRR's).

Mutually Exclusive Projects | |||

Project | Cash flow now ($) |
Cash flow in one year ($) |
IRR (% pa) |

Rent then sell as is | -900,000 | 990,000 | 10 |

Refurbishment into modern offices | -2,000,000 | 2,400,000 | 20 |

Conversion into residential apartments | -3,000,000 | 3,400,000 | 13.33 |

Which project should the investor accept?

Your friend just bought a house for $400,000. He financed it using a $320,000 mortgage loan and a deposit of $80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So ##V=D+E##.

If house prices suddenly fall by **10**%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell.

Remember:

### r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0} ###

where ##r_{0-1}## is the return (percentage change) of an asset with price ##p_0## initially, ##p_1## one period later, and paying a cash flow of ##c_1## at time ##t=1##.

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).

**Question 282** expected and historical returns, income and capital returns

You're the boss of an investment bank's equities research team. Your five analysts are each trying to find the **expected total return** over the next year of shares in a mining company. The mining firm:

- Is regarded as a mature company since it's quite stable in size and was floated around 30 years ago. It is not a high-growth company;
- Share price is very sensitive to changes in the price of the market portfolio, economic growth, the exchange rate and commodities prices. Due to this, its standard deviation of total returns is much higher than that of the market index;
- Experienced tough times in the last 10 years due to unexpected falls in commodity prices.
- Shares are traded in an active liquid market.

Assume that:

- The analysts' source data is correct and true, but their inferences might be wrong;
- All returns and yields are given as effective annual nominal rates.

**Question 558** portfolio weights, portfolio return, short selling

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of **16**% pa.

- Stock A has an expected return of
**8**% pa. - Stock B has an expected return of
**12**% pa.

What portfolio weights should the investor have in stocks A and B respectively?

**Question 556** portfolio risk, portfolio return, standard deviation

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of **12**% pa.

- Stock A has an expected return of
**10**% pa and a standard deviation of**20**% pa. - Stock B has an expected return of
**15**% pa and a standard deviation of**30**% pa.

The correlation coefficient between stock A and B's expected returns is **70**%.

What will be the annual standard deviation of the portfolio with this 12% pa target return?

Portfolio Details | ||||||

Stock | Expected return |
Standard deviation |
Correlation | Dollars invested |
||

A | 0.1 | 0.4 | 0.5 | 60 | ||

B | 0.2 | 0.6 | 140 | |||

What is the expected return of the above portfolio?

What is the covariance of a variable X with itself?

The cov(X, X) or ##\sigma_{X,X}## equals:

What is the correlation of a variable X with itself?

The corr(X, X) or ##\rho_{X,X}## equals:

The accounting identity states that the book value of a company's assets (A) equals its liabilities (L) plus owners equity (OE), so A = L + OE.

The finance version states that the market value of a company's assets (V) equals the market value of its debt (D) plus equity (E), so V = D + E.

Therefore a business's assets can be seen as a portfolio of the debt and equity that fund the assets.

Let ##\sigma_\text{V total}^2## be the total variance of returns on assets, ##\sigma_\text{V syst}^2## be the systematic variance of returns on assets, and ##\sigma_\text{V idio}^2## be the idiosyncratic variance of returns on assets, and ##\rho_\text{D idio, E idio}## be the correlation between the idiosyncratic returns on debt and equity.

Which of the following equations is **NOT** correct?