Question 1032 inflation, percent of sales forecasting, no explanation
Investment bank Canaccord's Think Childcare (TNK) initiation of coverage states: "Building lease costs – Rent expense is the second largest cost and TNK reported rent/sales of 12.1%, within the industry range that we typically see as 12-14% of sales. TNK lease all their properties and do not intend to own property. Leases are generally long term with 10-15 year terms and additional options. Although terms vary across properties and landlords, rental increases are generally tied to the consumer price index (CPI)" (Canaccord, 2016).
Assuming that sales grow faster than the CPI, when Canaccord forecast TNK's building lease costs using the 'percent of sales' method, that proportion should:
Question 1029 Buffett ratio
Tesla CEO Elon Musk asked a question to ARK Invest CEO Cathie Wood on 6 April 2021: "What do you think of the unusually high ratio of the S&P market cap to GDP?", to which Cathie Wood replied.
What are the units of this S&P500 market cap to GDP ratio, commonly known as the Buffett ratio?
Question 1022 inflation linked bond, breakeven inflation rate, inflation, real and nominal returns and cash flows
Below is a graph of 10-year US treasury fixed coupon bond yields (red), inflation-indexed bond yields (green) and the 'breakeven' inflation rate (blue). Note that inflation-indexed bonds are also called treasury inflation protected securities (TIPS) in the US. In other countries they're called inflation-linked bonds (ILB's). For more information, see PIMCO's great article about inflation linked bonds here.
The 10 year breakeven inflation rate (blue) equals the:
Question 1023 monetary policy, inflation, breakeven inflation rate
If the breakeven inflation rate was far above the US Fed's long term 2% average inflation target, the Fed would be expected to:
PIMCO gives the following example of an Inflation Linked Bond (ILB), called Treasury Inflation Protected Securities (TIPS) in the US.
How do ILBs work?
An ILB’s explicit link to a nationally-recognized inflation measure means that any increase in price levels directly translates into higher principal values. As a hypothetical example, consider a $1,000 20-year U.S. TIPS with a 2.5% coupon (1.25% on semiannual basis), and an inflation rate of 4%. The principal on the TIPS note will adjust upward on a daily basis to account for the 4% inflation rate. At maturity, the principal value will be $2,208 (4% per year, compounded semiannually). Additionally, while the coupon rate remains fixed at 2.5%, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. The first semiannual coupon of 1.25% paid on the inflation-adjusted principal of $1,020 is $12.75, while the final semiannual interest payment will be 1.25% of $2,208, which is $27.60.
Forecast the semi-annual coupon paid in 10 years based on the bond details given above. The 20th semi-annual coupon, paid in 10 years, is expected to be:
What proportion of managers are evaluating projects correctly, based on table 8 from Meier and Tarhan's (2006) survey of corporate managers?
| Table 8: Consistency of nominal or real hurdle rates and cash flows | |||
| Hurdle rate | Cash flows | Total | |
|---|---|---|---|
| Nominal | Real | ||
| Nominal | 29.8% | 11.6% | 41.3% |
| Real | 19.8% | 38.4% | 58.7% |
| Total | 49.6% | 50.4% | 100.0% |
Table 8 footnote: The rows in this cross-tabulation show whether the firm uses a nominal or real hurdle rate, the columns indicate whether cash flows are calculated in nominal or real terms. The fractions denote the number of firms for each combination relative to the total of 123 respondents that responded to both separate survey questions.
What proportion of managers are evaluating projects correctly?
Former Reserve Bank of Australia (RBA) Governor Phil Lowe says that the RBA cash rate is the interest rate in the Australian:
Former RBA Governor Phil Lowe says that if the economy is growing very strongly, then prices might be growing too:
Former RBA Governor Phil Lowe says that when the RBA raise interest rates, homeowners' mortgage loan interest expense will be:
Question 1019 RBA cash rate, monetary policy, wealth effect
Former RBA Governor Phil Lowe says that when the RBA raise the cash rate, asset prices tend to:
Question 1020 Federal funds rate, monetary policy, dot plot
US Federal Reserve Chair Jerome Powell showed the 'dot plot' of Federal Open Market Committee (FOMC) members' estimated future Fed fund rates following their quarterly summary of economic projections on 15 Dec 2021. The dot plot shows that committee members intended to make monetary policy more:
Question 1021 Federal funds rate, monetary policy, quantitative easing, tapering
US Fed Chair Jerome Powell held a news conference following the 25-26 January 2022 FOMC meeting.
Nick Timiraos reporting for The Wall Street Journal asked: "Raising rates and reducing the balance sheet both restrain the economy, both tighten monetary policy. How should we think about the relationship between the two? For example, how much passive runoff is equal to every quarter percentage point increase in your benchmark rate?"
Jerome Powell replied: "So, again, we think of the balance sheet as moving in a predictable manner, sort of in the background, and that the active tool meeting to meeting is not -- both of them, it's the federal funds rate. There are rules of thumbs. I'm reluctant to land on one of them that equate this. And there's also an element of uncertainty around the balance sheet. I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we're less certain about that." (US Fed, 2022)
When Nick Timiraos mentioned 'reducing the balance sheet', he's referring to:
A stock has a beta of 1.2. Its next dividend is expected to be $20, paid one year from now.
Dividends are expected to be paid annually and grow by 1.5% pa forever.
Treasury bonds yield 3% pa and the market portfolio's expected return is 7% pa. All returns are effective annual rates.
What is the price of the stock now?
Question 935 real estate, NPV, perpetuity with growth, multi stage growth model, DDM
You're thinking of buying an investment property that costs $1,000,000. The property's rent revenue over the next year is expected to be $50,000 pa and rent expenses are $20,000 pa, so net rent cash flow is $30,000. Assume that net rent is paid annually in arrears, so this next expected net rent cash flow of $30,000 is paid one year from now.
The year after, net rent is expected to fall by 2% pa. So net rent at year 2 is expected to be $29,400 (=30,000*(1-0.02)^1).
The year after that, net rent is expected to rise by 1% pa. So net rent at year 3 is expected to be $29,694 (=30,000*(1-0.02)^1*(1+0.01)^1).
From year 3 onwards, net rent is expected to rise at 2.5% pa forever. So net rent at year 4 is expected to be $30,436.35 (=30,000*(1-0.02)^1*(1+0.01)^1*(1+0.025)^1).
Assume that the total required return on your investment property is 6% pa. Ignore taxes. All returns are given as effective annual rates.
What is the net present value (NPV) of buying the investment property?
Question 989 PE ratio, Multiples valuation, leverage, accounting ratio
A firm has 20 million stocks, earnings (or net income) of $100 million per annum and a 60% debt-to-equity ratio where both the debt and asset values are market values rather than book values. Similar firms have a PE ratio of 12.
Which of the below statements is NOT correct based on a PE multiples valuation?
A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged.
Ignoring the costs of financial distress, which of the following statements is NOT correct:
A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.
To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:
###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###
Which point corresponds to the best time to calculate the terminal value?
An old company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.
To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:
###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###
Which point corresponds to the best time to calculate the terminal value?
A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.
To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:
###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###
Which point corresponds to the best time to calculate the terminal value?
Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $100m | Operating free cash flow |
| ##\text{FFCF or CFFA}## | $112m | Firm free cash flow or cash flow from assets (includes interest tax shields) |
| ##g## | 0% pa | Growth rate of OFCF and FFCF |
| ##\text{WACC}_\text{BeforeTax}## | 7% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 6.25% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Cost of debt |
| ##r_\text{EL}## | 9% pa | Cost of levered equity |
| ##D/V_L## | 50% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
What is the value of the levered firm including interest tax shields?
Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $48.5m | Operating free cash flow |
| ##\text{FFCF or CFFA}## | $50m | Firm free cash flow or cash flow from assets |
| ##g## | 0% pa | Growth rate of OFCF and FFCF |
| ##\text{WACC}_\text{BeforeTax}## | 10% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 9.7% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Cost of debt |
| ##r_\text{EL}## | 11.25% pa | Cost of levered equity |
| ##D/V_L## | 20% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
What is the value of the levered firm including interest tax shields?
Use the below information to value a levered company with annual perpetual cash flows from assets that grow. The next cash flow will be generated in one year from now. Note that ‘k’ means kilo or 1,000. So the $30k is $30,000.
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $30k | Operating free cash flow |
| ##g## | 1.5% pa | Growth rate of OFCF |
| ##r_\text{D}## | 4% pa | Cost of debt |
| ##r_\text{EL}## | 16.3% pa | Cost of levered equity |
| ##D/V_L## | 80% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
| ##n_\text{shares}## | 100k | Number of shares |
Which of the following statements is NOT correct?
Use the below information to value a mature levered company with growing annual perpetual cash flows and a constant debt-to-assets ratio. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. The firm's debt funding comprises annual fixed coupon bonds that all have the same seniority and coupon rate. When these bonds mature, new bonds will be re-issued, and so on in perpetuity. The yield curve is flat.
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}_1## | $12.5m | Operating free cash flow at time 1 |
| ##\text{FFCF}_1 \text{ or }\text{CFFA}_1## | $14m | Firm free cash flow or cash flow from assets at time 1 |
| ##\text{EFCF}_1## | $11m | Equity free cash flow at time 1 |
| ##\text{BondCoupons}_1## | $1.2m | Bond coupons paid to debt holders at time 1 |
| ##g## | 2% pa | Growth rate of OFCF, FFCF, EFCF and Debt cash flow |
| ##\text{WACC}_\text{BeforeTax}## | 9% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 8.25% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Bond yield |
| ##r_\text{EL}## | 13% pa | Cost or required return of levered equity |
| ##D/V_L## | 50% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##n_\text{shares}## | 1m | Number of shares |
| ##t_c## | 30% | Corporate tax rate |
Which of the following statements is NOT correct?
Over the next year, the management of an unlevered company plans to:
- Make $5m in sales, $1.9m in net income and $2m in equity free cash flow (EFCF).
- Pay dividends of $1m.
- Complete a $1.3m share buy-back.
Assume that:
- All amounts are received and paid at the end of the year so you can ignore the time value of money.
- The firm has sufficient retained profits to legally pay the dividend and complete the buy back.
- The firm plans to run a very tight ship, with no excess cash above operating requirements currently or over the next year.
How much new equity financing will the company need? In other words, what is the value of new shares that will need to be issued?
There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA). Some include the annual interest tax shield in the cash flow and some do not.
Which of the below FFCF formulas include the interest tax shield in the cash flow?
###(1) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp### ###(2) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp.(1-t_c)### ###(3) \quad FFCF=EBIT.(1-t_c )+ Depr- CapEx -ΔNWC+IntExp.t_c### ###(4) \quad FFCF=EBIT.(1-t_c) + Depr- CapEx -ΔNWC### ###(5) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC+IntExp.t_c### ###(6) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC### ###(7) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC### ###(8) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC-IntExp.t_c### ###(9) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC### ###(10) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC-IntExp.t_c###The formulas for net income (NI also called earnings), EBIT and EBITDA are given below. Assume that depreciation and amortisation are both represented by 'Depr' and that 'FC' represents fixed costs such as rent.
###NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )### ###EBIT=Rev - COGS - FC-Depr### ###EBITDA=Rev - COGS - FC### ###Tax =(Rev - COGS - Depr - FC - IntExp).t_c= \dfrac{NI.t_c}{1-t_c}###Question 413 CFFA, interest tax shield, depreciation tax shield
There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA).
One method is to use the following formulas to transform net income (NI) into FFCF including interest and depreciation tax shields:
###FFCF=NI + Depr - CapEx -ΔNWC + IntExp###
###NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )###
Another popular method is to use EBITDA rather than net income. EBITDA is defined as:
###EBITDA=Rev - COGS - FC###
One of the below formulas correctly calculates FFCF from EBITDA, including interest and depreciation tax shields, giving an identical answer to that above. Which formula is correct?
Meier and Tarhan (2006) conducted an interesting survey of corporate managers. The results are copied in Table 7 below. What proportion of managers are evaluating levered projects correctly?
| Table 7: Consistency between hurdle rate and the calculation of cash flows | |||||||
| Hurdle rate | Cash flow calculation (see below notes) | ||||||
|---|---|---|---|---|---|---|---|
| (i) | (ii) | (iii) | (iv) | (v) | Other | Total | |
| WACC | 11.3% | 34.8% | 1.7% | 3.5% | 18.3% | 1.7% | 71.3% |
| Equity levered | 0.0% | 2.6% | 0.9% | 0.0% | 0.9% | 0.9% | 6.1% |
| Equity unlevered | 1.7% | 1.7% | 0.9% | 0.9% | 1.7% | 0.9% | 7.8% |
| Other | 2.6% | 5.2% | 1.7% | 0.9% | 3.5% | 0.9% | 14.8% |
| Total | 16.5% | 44.4% | 5.2% | 5.2% | 24.4% | 4.4% | 100.0% |
The rows of the cross-tabulation indicate what the self-reported hurdle rate represents and the columns denote five different ways to calculate cash flows, (i) to (v), plus the “other” category. Each cell then displays the fraction of all 113 respondents for a given combination of what the hurdle rate represents and how the firm calculates its cash flows when evaluating a project.
The definitions of the cash flow calculations (i)-(v) are as follows:
(i) Earnings before interest and after taxes (EBIAT) + depreciation
(ii) Earnings before interest and after taxes (EBIAT) + depreciation – capital expenditures – net change in working capital
(iii) Earnings
(iv) Earnings + depreciation
(v) Earnings + depreciation – capital expenditures – net change in working capital
Assume that the WACC is after tax, the required return on unlevered equity is the WACC before tax, all projects are levered, the benefit of interest tax shields should be included in the valuation, earnings = net profit after tax (NPAT) and EBIAT = EBIT*(1-tc) which is often also called net operating profit after tax (NOPAT).
What proportion of managers are evaluating levered projects correctly?
Question 905 market capitalisation of equity, PE ratio, payout ratio
The below graph shows the computer software company Microsoft's stock price (MSFT) at the market close on the NASDAQ on Friday 1 June 2018.
Based on the screenshot above, which of the following statements about MSFT is NOT correct? MSFT's:
Which of the following statements about Macaulay duration is NOT correct? The Macaulay duration:
Question 566 capital structure, capital raising, rights issue, on market repurchase, dividend, stock split, bonus issue
A company's share price fell by 20% and its number of shares rose by 25%. Assume that there are no taxes, no signalling effects and no transaction costs.
Which one of the following corporate events may have happened?
Find the Macaulay duration of a 2 year 5% pa annual fixed coupon bond which has a $100 face value and currently has a yield to maturity of 8% pa. The Macaulay duration is:
Find the Macaulay duration of a 2 year 5% pa semi-annual fixed coupon bond which has a $100 face value and currently has a yield to maturity of 8% pa. The Macaulay duration is:
Assume that the market portfolio has a duration of 15 years and an individual stock has a duration of 20 years.
What can you say about the stock's (single factor CAPM) beta with respect to the market portfolio? The stock's beta is likely to be:
Question 999 duration, duration of a perpetuity with growth, CAPM, DDM
A stock has a beta of 0.5. Its next dividend is expected to be $3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. All returns are effective annual rates.
What is the Macaulay duration of the stock now?
Below is a table showing GMO's 2016 estimates of different assets' durations, appearing in Slater (2017).
If you were certain that interest rates would fall more than the market expects, into what asset might you allocate more funds?
A stock has a beta of 0.5. Its next dividend is expected to be $3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 3% pa and the market risk premium (MRP) is 6% pa. All returns are effective annual rates.
Which of the following statements is NOT correct?
Question 1034 duration, monetary policy, inflation, market efficiency
On 18 March 2022 the AFR's James Thomson wrote: "In a world where the bombs are still falling in Ukraine and the Fed is just getting started on what looks likely to be a year-long cycle of rising interest rates, it would take a certain amount of bravery to embrace the sort of high-tech, long duration plays that Wood favours" (Thomson, 2022).
Which of the following US macro-economic data releases is most likely to cause Cathie Wood's ARK ETF share price to fall?
Question 871 duration, Macaulay duration, modified duration, portfolio duration
Which of the following statements about Macaulay duration is NOT correct? The Macaulay duration:
Question 872 duration, Macaulay duration, modified duration, portfolio duration
A fixed coupon bond’s modified duration is 20 years, and yields are currently 10% pa compounded annually. Which of the following statements about the bond is NOT correct?
Question 918 duration, Macaulay duration, modified duration, bond convexity
A fixed coupon bond’s modified duration is 10 years, and yields are currently 5% pa compounded annually. Which of the following statements about the bond is NOT correct?
Which of the following statements about bond convexity is NOT correct?
An analyst has prepared a discounted cash flow model to value a firm's share price. A sensitivity analysis data table with ‘conditional formatting’ shading is shown below. The table shows how changes in the weighted average cost of capital (WACC, left column) and terminal value growth rate (top row) affect the firm's model-estimated share price.
The base case estimates are shown in bold.
Which of the following statements is NOT correct? The model-estimated share price would normally be expected to:
Canaccord conducts a sensitivity analysis of the Israeli pharmaceutical firm InterCure's (INCR) estimated share price in figure 33 on page 30:
Estimate the Macaulay duration of INCR's equity. The Macaulay duration is approximately:
Question 1039 gross domestic product, inflation, business cycle
In this business cycle graph shown in the RBA's article explaining recessions, how might 'output' on the y-axis be measured?
The ‘output’ y-axis amount in the business cycle chart can be measured by:
Question 852 gross domestic product, inflation, employment, no explanation
When the economy is booming (in an upswing), you tend to see:
Calculate Australia’s GDP over the 2016 calendar year using the below table:
| Australian Gross Domestic Product Components | ||||
| A$ billion, 2016 Calendar Year from 1 Jan 2016 to 31 Dec 2016 inclusive | ||||
| Consumption | Investment | Government spending | Exports | Imports |
| 971 | 421 | 320 | 328 | 344 |
Source: ABS 5206.0 Australian National Accounts: National Income, Expenditure and Product. Table 3. Expenditure on Gross Domestic Product (GDP), Current prices.
Over the 2016 calendar year, Australia’s GDP was:
Question 850 gross domestic product, gross domestic product per capita
Below is a table showing some countries’ GDP, population and GDP per capita.
| Countries' GDP and Population | |||
| GDP | Population | GDP per capita | |
| USD million | millions of people | USD | |
| United States | 18,036,648 | 325 | 55,492 |
| China | 11,158,457 | 1,383 | 8,066 |
| Japan | 4,383,076 | 127 | 34,586 |
| Germany | 3,363,600 | 83 | 40,623 |
| Norway | 500,519 | 5 | 95,027 |
Source: "GDP and its breakdown at current prices in US Dollars" United Nations Statistics Division. December 2016.
Using this data only, which one of these countries’ citizens have the highest living standards?
Which form of production is included in the Gross Domestic Product (GDP) reported by the government statistics agency?
Question 1053 bond pricing, monetary policy, supply and demand
In his 31 August 2021 article 'The rich get richer and rates get lower', Robert Armstrong states that: "Savings chase returns, so when there are more savings and the same number of places to put them, rates of return must fall" (Armstrong, 2021).
Another way of saying that "rates of return must fall" when there are more savings (loanable funds) invested into fixed coupon government and corporate bonds, is that increased:
Question 1035 Minsky financial instability hypothesis, leverage
Which of the following statements about 'The Financial Instability Hypothesis' (Minsky, 1992) is NOT correct? Borrowers with sufficient income to pay:
Question 1036 Minsky financial instability hypothesis, leverage
Hyman Minsky, author of 'The Financial Instability Hypothesis' (1992), wrote:
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
Which of the below statements explaining this quote is NOT correct?
What effect is being referred to in the following quote from the MARTIN model description?
Economy-wide models also account for feedback between economic variables. For example, an increase in aggregate demand will encourage firms to hire more workers, which raises employment and lowers the unemployment rate. The tightening of the labour market is likely to lead to an increase in wages growth. The resulting increase in household incomes is likely to lead to an increase in consumption, further raising aggregate demand. (Ballantyne et al, 2019)
The name of the effect being referred to is:
Question 1038 fire sale, leverage, no explanation
Listen to 'Lessons and Questions from the GFC' on 6 December 2018 by RBA Deputy Governor Guy Debelle from 17:58 to 20:08 or read the below transcript:
Guy Debelle talks about the GFC and says that the Australian government’s guarantee of wholesale debt and deposits on 12 October 2008 was "introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium... The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy." (Debelle, 2019)
When assets are sold in a fire sale, there’s usually a large increase in the:
Here's an excerpt from an interview between Magellan fund co-founder Hamish Douglass and AFR reporter Vesna Poljak, which appeared in the Australian Financial Review article ‘It's all about interest rates: Hamish Douglass’, 19 July 2019:
Take a business growing at 4 per cent a year, with a cost of equity of 10 per cent based off a 5 per cent risk-free rate and a 5 per cent market risk premium: you would value that at around 16.6 times free cashflow.
Now take a business growing at the same rate, with a 4 per cent risk free rate. At a 9 per cent cost of equity that would command a 20 times multiple, he says.
At a 3 per cent risk-free rate, the cost of equity is 8 per cent, and the multiple is 25.
Finally at 2 per cent – 'which is where the world is at the moment' – the same business would be worth around 33 times free cashflow.
In August 2021, the RBA overnight cash rate and 3 year Australian government treasury bond yield were both 0.1% pa. If this low risk-free yield was expected to persist forever, what approximate equity price-to-cashflow multiple would that imply for a business expected to grow at 4% pa in perpetuity with a 5% equity risk premium?
In the 1997 Asian financial crisis many countries' exchange rates depreciated rapidly against the US dollar (USD). The Thai, Indonesian, Malaysian, Korean and Filipino currencies were severely affected. The below graph shows these Asian countries' currencies in USD per one unit of their currency, indexed to 100 in June 1997.
Of the statements below, which is NOT correct? The Asian countries':
Question 882 Asian currency crisis, foreign exchange rate, original sin, no explanation
In the 1997 Asian currency crisis, the businesses most vulnerable to bankruptcy were those that:
Question 1051 monetary policy, equilibrium real interest rate, inequality, marginal propensity to consume, gross domestic product, bond pricing
Read the below quote for background, or skip it to answer the question immediately.
In his 31 August 2021 article 'The rich get richer and rates get lower', Robert Armstrong states that:
"Atif Mian, Ludwig Straub and Amir Sufi agree with partisans of the demographic view, such as the economists Charles Goodhart and Manoj Pradhan, that a key contributor to falling rates is higher savings.
Mian, Straub and Sufi disagree, however, about why there are ever more savings sloshing around. It is not because the huge baby-boom generation is getting older and saving more (a trend that will change direction soon, when they are all retired). Rather, it’s because a larger and larger slice of national income is going to the top decile of earners. Because a person can only consume so much, the wealthy few tend to save much of this income rather than spend it. This pushes rates down directly, when those savings are invested, driving asset prices up and yields down; and indirectly, by sapping aggregate demand.
Why doesn’t all the cash that the rich push into markets get converted, ultimately, into productive investment, either at home or abroad? Tricky question. For present purposes it is enough to note that this is not happening — the savings of the American rich reappear, instead, as debt, owed by the government or by lower-income US households. (In another paper, MS&S have pointed out that this means the high share of income going to the rich hurts aggregate demand in two ways: the rich have a lower marginal propensity to consume, and governments and the non-rich are forced to shift dollars from consumption to debt service. Economically speaking, high inequality is a real buzzkill.)
MS&S prefer the inequality explanation for two reasons. Using data from the Fed’s Survey of Consumer Finances (which goes back to 1950) they show that differences in savings rates are much greater within any given age cohort than across age cohorts. That is, savings are building up faster because the rich are getting richer, not because the baby boomers are getting older."
Which of the following statements about this quote is NOT correct?
Question 1052 monetary policy, equilibrium real interest rate, marginal propensity to consume, gross domestic product, bond pricing
In the below chart by Rachel and Summers (2019), the red dotted line depicts the decline in advanced economies’ (AE) equilibrium real interest rate (R*) in percentage points since the 1970’s. The authors attribute this to the factors represented by columns above and below the x-axis. The sum of these columns is given by the black line labelled 'Total response of R* in the GE (general equilibrium) models'.
Which of the below statements about this graph is NOT correct?
Question 1013 book build, initial public offering, capital raising, demand schedule
A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:
| IPO Book Build Bids | ||
| Bidders | Share price | Number of shares |
| $/share | millions | |
| BidderA | 2.5 | 2 |
| BidderB | 2 | 1.5 |
| BidderC | 1.5 | 4 |
| BidderD | 1 | 3 |
| BidderE | 0.5 | 2 |
Suppose that the firm's owner wishes to sell all of their 8 million shares, so no new money will be raised and no money will re-invested back into the firm. Which of the following statements is NOT correct?
Question 1014 book build, initial public offering, capital raising, demand schedule
A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:
| IPO Book Build Bids | ||
| Bidders | Share price | Number of shares |
| $/share | millions | |
| BidderA | 2.5 | 2 |
| BidderB | 2 | 1.5 |
| BidderC | 1.5 | 4 |
| BidderD | 1 | 3 |
| BidderE | 0.5 | 2 |
Suppose that the firm's owner wishes to raise $6 million to expand the business by selling new stock in the initial public offering (IPO). The owner currently holds 8 million stock which are not for sale. Which of the following statements is NOT correct?
Question 568 rights issue, capital raising, capital structure
A company conducts a 1 for 5 rights issue at a subscription price of $7 when the pre-announcement stock price was $10. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order. Ignore all taxes, transaction costs and signalling effects.
Question 625 dividend re-investment plan, capital raising
Which of the following statements about dividend re-investment plans (DRP's) is NOT correct?
A company conducts a 2 for 3 rights issue at a subscription price of $8 when the pre-announcement stock price was $9. Assume that all investors use their rights to buy those extra shares.
What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.
A firm wishes to raise $50 million now. They will issue 7% pa semi-annual coupon bonds that will mature in 6 years and have a face value of $100 each. Bond yields are 5% pa, given as an APR compounding every 6 months, and the yield curve is flat.
How many bonds should the firm issue?
A firm wishes to raise $100 million now. The firm's current market value of equity is $300m and the market price per share is $5. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $4. All answers are rounded to 6 decimal places. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?
A firm wishes to raise $30 million now. The firm's current market value of equity is $60m and the market price per share is $20. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $15. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?
Question 803 capital raising, rights issue, initial public offering, on market repurchase, no explanation
Which one of the following capital raisings or payouts involve the sale of shares to existing shareholders only?
Question 1009 lemons problem, asymmetric information, adverse selection
Akerlof’s 1970 paper ‘The Market for "Lemons": Quality Uncertainty and the Market Mechanism’ provides a famous example of asymmetric information leading to market failure. This example is commonly known as the ‘Lemons Problem’. Imagine that half of all second hand cars are:
- Lemons worth $5,000 each. Lemons are bad second-hand cars with hidden faults that only the seller knows about; and the other half are
- Plums worth $10,000 each. Plums are good second-hand cars without faults.
Car buyers can’t tell the difference between lemon and plum cars.
Car sellers know whether their car is a lemon or a plum since they’ve driven the car for a long time. However, plum car owners cannot prove their cars’ higher quality to buyers. Also, lemon car owners are known to dis-honestly claim that their cars are plums.
What will be the market price of second hand cars?
Question 1010 lemons problem, asymmetric information, adverse selection, fungible
The ‘Lemons Problem’ is likely to more adversely affect the desirability of which type of investment?
Question 1011 winners curse
A teacher fills up a large jar with coins. The jar is auctioned among a large class of wealthy accounting students who have never studied economics or finance.
The auction is conducted in the English style, which is as an open-outcry ascending auction. This means that the winning bidder is able to bid, win and pay slightly more than the second highest bidder's private valuation, but less than their own private valuation.
The jar of coins is not allowed to be weighed by students and is filled with different-valued coins so it’s difficult to value. Therefore there is a wide distribution of bidders’ fair value estimates. Students’ bids are purely profit-driven, there is no fame to be gained by being the winner or loser.
Assume that each bidder bids up to their personal estimate of the fair value of the jar of coins without observing the number of other bidders during the auction. The winning bidder is likely to:
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
| Balance Sheet Market Values and Betas | ||
| Balance sheet item | Market value ($m) | Beta |
| Cash asset | 0.5 | 0 |
| Truck assets | 0.5 | 2 |
| Loan liabilities | 0.25 | 0.1 |
| Equity funding | ? | ? |
Which of the following statements is NOT correct?
Question 1045 payout policy, leverage, capital structure, beta
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
| Balance Sheet Market Values and Betas | ||
| Balance sheet item | Market value ($m) | Beta |
| Cash asset | 0.5 | 0 |
| Truck assets | 0.5 | 2 |
| Loan liabilities | 0.25 | 0.1 |
| Equity funding | ? | ? |
The firm then pays out all of its cash as a dividend. Assume that the beta and yield on the loan liability remain unchanged. Ignore taxes, transaction costs, signalling, information asymmetries and other frictions.
Which of the following statements is NOT correct? This event led to a:
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
| Balance Sheet Market Values and Betas | ||
| Balance sheet item | Market value ($m) | Beta |
| Cash asset | 0.5 | 0 |
| Truck assets | 0.5 | 2 |
| Loan liabilities | 0.25 | 0.1 |
| Equity funding | ? | ? |
The firm then pays off (retires) all of its loan liabilities using its cash. Ignore interest tax shields.
Which of the following statements is NOT correct? All answers are given to 6 decimal places. This event led to a:
Question 1047 five Cs of credit, banking, debt terminology, Loan, credit risk, risk, leverage, financial distress
Which of the following is NOT one of the "five C's" of credit used by bankers?
Which of the following income statement and balance sheet items should NOT be forecast using the 'percent of sales' technique?
Which of the following formulas for the carrying or net amount of 'intangible assets' such as patents from the balance sheet is correct? Assume that now is time 1 and last year is time 0, and that 'IntangibleAssets' is a carrying value net of accumulated depreciation.
Question 1058 book and market values, enterprise value, balance sheet
Here is a table from Canaccord's 'sum of the parts' valuation of INCR.
Note that the firm INCR is unlevered (interest bearing debt = 0).
The third column from the left is labelled 'Value (US$ MM)'. For the 'Israel' and 'EU Export' opportunities, these values are most likely to be:
The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.
A stock has a beta of 0.7.
In the last 5 minutes, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 2%. The risk free rate was unchanged. What do you think was the stock's historical return over the last 5 minutes, given as an effective 5 minute rate?
Question 729 book and market values, balance sheet, no explanation
If a firm makes a profit and pays no dividends, which of the firm’s accounts will increase?
Question 941 negative gearing, leverage, capital structure, interest tax shield, real estate
Last year, two friends Lev and Nolev each bought similar investment properties for $1 million. Both earned net rents of $30,000 pa over the past year. They funded their purchases in different ways:
- Lev used $200,000 of his own money and borrowed $800,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa.
- Nolev used $1,000,000 of his own money, he has no mortgage loan on his property.
Both Lev and Nolev also work in high-paying jobs and are subject personal marginal tax rates of 45%.
Which of the below statements about the past year is NOT correct?
Question 959 negative gearing, leverage, capital structure, interest tax shield, real estate
Last year, two friends Gear and Nogear invested in residential apartments. Each invested $1 million of their own money (their net wealth).
Apartments cost $1,000,000 last year and they earned net rents of $30,000 pa over the last year. Net rents are calculated as rent revenues less the costs of renting such as property maintenance, land tax and council rates. However, interest expense and personal income taxes are not deducted from net rents.
Gear and Nogear funded their purchases in different ways:
- Gear used $1,000,000 of her own money and borrowed $4,000,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa to buy 5 apartments.
- Nogear used $1,000,000 of his own money to buy one apartment. He has no mortgage loan on his property.
Both Gear and Nogear also work in high-paying jobs and are subject personal marginal tax rates of 45%.
Which of the below statements about the past year is NOT correct?
The DuPont formula is:
###\dfrac{\text{Net Profit}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Total Assets}} \times \dfrac{\text{Total Assets}}{\text{Owners' Equity}}###
Which of the following statements about the DuPont formula is NOT correct?
Question 983 corporate financial decision theory, DuPont formula, accounting ratio
A company manager is thinking about the firm's book assets-to-equity ratio, also called the 'equity multiplier' in the DuPont formula:
###\text{Equity multiplier} = \dfrac{\text{Total Assets}}{\text{Owners' Equity}}###What's the name of the decision that the manager is thinking about? In other words, the assets-to-equity ratio is the main subject of what decision?
Note: DuPont formula for analysing book return on equity:
###\begin{aligned} \text{ROE} &= \dfrac{\text{Net Profit}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Total Assets}} \times \dfrac{\text{Total Assets}}{\text{Owners' Equity}} \\ &= \text{Net profit margin} \times \text{Total asset turnover} \times \text{Equity multiplier} \\ \end{aligned}###Question 1069 Multiples valuation, venture capital, elasticity, DuPont formula, multi stage growth model
Read the below excerpt of AFR journalist Vesna Poljak's article 'What’s a start-up really worth' from 24 November 2020:
If Charlie Munger is right that earnings before interest, tax, depreciation and amortisation are “bullshit earnings”, and presenting adjusted EBITDA is “basic intellectual dishonesty”, someone should ask the 96-year-old Berkshire Hathaway vice-chairman what he thinks of revenue multiples.
It’s a necessary evil of this bull market that so many companies are now valued on multiples of their sales, as opposed to profits, typically because they don’t have any of the latter. It’s also impossible to ignore that real money investors are backing businesses at “multi-unicorn” valuations, meaning that capital is being allocated on an assumption lying somewhere between a considered ability to correctly recognise future growth, and magical thinking.
The idea is that, eventually, these businesses will arrive at a point where their constant reinvestment in sales and marketing, customer acquisition, and systems and process (all items that appear below the revenue line) will no longer be necessary, thereby allowing profits to suddenly crystallise.
Our baby unicorn is now a cloud-based workhorse with stunning margins, low operational costs, a market-dominant position and loyal customers totally insensitive to price increases.
Forecasts and evangelical founders are the natural enemies of a sound mind. “These businesses are very different compared to the typical mature business,” says PwC partner Richard Stewart. “They’re very heavily intangible-asset focused so traditional accounting doesn’t describe the performance of the business well.
“They’re also very risk intensive: it’s a bit like they’re climbing Everest, they’ve got halfway and there’s still a long way to the summit. The start-up sees how far they’ve come from base camp, the investor sees how far they have to go.”
EY partner Michael Fenech said that once upon a time, revenue multiples were used to value companies in very limited circumstances. “Now, revenue multiples have emerged as one of the primary valuation methodologies that people are using, which concerns people like myself.”
A robust valuation should be underpinned, wherever possible, by cash-flow forecasts, Fenech says. “So if we see companies relying on revenue multiples, our level of scepticism is often heightened and we start asking other questions.”
Which of the below statements is NOT correct?
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A cash offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 6,000 | 700 |
| Debt ($m) | 4,800 | 400 |
| Share price ($) | 40 | 20 |
| Number of shares (m) | 30 | 15 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A scrip offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 6,000 | 700 |
| Debt ($m) | 4,800 | 400 |
| Share price ($) | 40 | 20 |
| Number of shares (m) | 30 | 15 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The firms operate in different industries and the CEO's rationale for the merger is to increase diversification and thereby decrease risk. The deal is not expected to create any synergies. An 80% scrip and 20% cash offer will be made that pays the fair price for the target's shares. The cash will be paid out of the firms' cash holdings, no new debt or equity will be raised.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 6,000 | 700 |
| Debt ($m) | 4,800 | 400 |
| Share price ($) | 40 | 20 |
| Number of shares (m) | 30 | 15 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A 40% scrip and 60% cash offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 6,000 | 700 |
| Debt ($m) | 4,800 | 400 |
| Share price ($) | 40 | 20 |
| Number of shares (m) | 30 | 15 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $2 million. A cash offer will be made that pays the fair price for the target's shares plus 70% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 60 | 10 |
| Debt ($m) | 20 | 2 |
| Share price ($) | 10 | 8 |
| Number of shares (m) | 4 | 1 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $2 million. A scrip offer will be made that pays the fair price for the target's shares plus 70% of the total synergy value.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 60 | 10 |
| Debt ($m) | 20 | 2 |
| Share price ($) | 10 | 8 |
| Number of shares (m) | 4 | 1 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $0.5 million, but investment bank fees and integration costs with a present value of $1.5 million is expected. A 10% cash and 90% scrip offer will be made that pays the fair price for the target's shares only. Assume that the Target and Acquirer agree to the deal. The cash will be paid out of the firms' cash holdings, no new debt or equity will be raised.
| Firms Involved in the Takeover | ||
| Acquirer | Target | |
| Assets ($m) | 60 | 10 |
| Debt ($m) | 20 | 2 |
| Share price ($) | 10 | 8 |
| Number of shares (m) | 4 | 1 |
Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $1 billion, corresponding to extra earnings of $0.05 billion per year.
A 70% scrip and 30% cash offer will be made that pays the fair price for the target's shares plus $0.4 billion of the available synergies, corresponding to extra earnings of $0.02 billion per year. The cash will be paid out of the firm's existing cash holdings, so no new debt or equity will be raised.
| Firms Involved in the Takeover | |||
| Acquirer | Target | Merged | |
| Assets ($b) | 12 | 5 | ? |
| Debt ($b) | 7 | 2 | (a) |
| Equity ($b) | 5 | 3 | ? |
| Share price ($/share) | 10 | 2 | (b) |
| Number of shares (b) | 0.5 | 1.5 | (c) |
| Earnings ($b/year) | 0.25 | 0.15 | (d) |
| EPS ($/share) | 0.5 | 0.1 | ? |
| PE ratio (years) | 20 | 20 | ? |
Assume that:
- The acquirer's cash holdings are in a liquid account paying zero interest;
- The cash will be paid out of the firm's cash holdings, so no new debt or equity will be raised;
- There are no transaction costs or fees;
- The firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant;
- The acquisition is planned to occur immediately, so ignore the time value of money.
Which of the following statements is NOT correct? The merged firm will have:
You believe that the price of a share will fall significantly very soon, but the rest of the market does not. The market thinks that the share price will remain the same. Assuming that your prediction will soon be true, which of the following trades is a bad idea? In other words, which trade will NOT make money or prevent losses?
A man just sold a call option to his counterparty, a lady. The man has just now:
A European call option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.
What is an expression for the payoff at maturity ##(f_T)## in dollars from owning (being long) the call option?
A European put option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.
What is an expression for the payoff at maturity ##(f_T)## in dollars from owning (being long) the put option?
A European call option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.
What is an expression for the payoff at maturity ##(f_T)## in dollars from having written (being short) the call option?
A European put option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.
What is an expression for the payoff at maturity ##(f_T)## in dollars from having written (being short) the put option?
Question 432 option, option intrinsic value, no explanation
An American style call option with a strike price of ##K## dollars will mature in ##T## years. The underlying asset has a price of ##S## dollars.
What is an expression for the current intrinsic value in dollars from owning (being long) the American style call option? Note that the intrinsic value of an option does not subtract the premium paid to buy the option.
Which of the following statements about option contracts is NOT correct? For every:
If trader A has sold the right that allows counterparty B to buy the underlying asset from him at maturity if counterparty B wants then trader A is:
After doing extensive fundamental analysis of a company, you believe that their shares are overpriced and will soon fall significantly. The market believes that there will be no such fall.
Which of the following strategies is NOT a good idea, assuming that your prediction is true?
Question 636 option, option payoff at maturity, no explanation
Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being long a call option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.
Question 637 option, option payoff at maturity, no explanation
Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being short a call option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.
Question 638 option, option payoff at maturity, no explanation
Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being long a put option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.
Question 639 option, option payoff at maturity, no explanation
Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being short a put option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.
Which one of the below option and futures contracts gives the possibility of potentially unlimited gains?
A trader buys one crude oil European style call option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:
Which of the below formulas gives the profit ##(\pi)## from being long a call option? Let the underlying asset price at maturity be ##S_T##, the exercise price be ##X_T## and the option price be ##f_{LC,0}##. Note that ##S_T##, ##X_T## and ##f_{LC,0}## are all positive numbers.
Which of the below formulas gives the profit ##(\pi)## from being short a call option? Let the underlying asset price at maturity be ##S_T##, the exercise price be ##X_T## and the option price be ##f_{LC,0}##. Note that ##S_T##, ##X_T## and ##f_{LC,0}## are all positive numbers.
Which of the below formulas gives the profit ##(\pi)## from being long a put option? Let the underlying asset price at maturity be ##S_T##, the exercise price be ##X_T## and the option price be ##f_{LP,0}##. Note that ##S_T##, ##X_T## and ##f_{LP,0}## are all positive numbers.
Which of the below formulas gives the profit ##(\pi)## from being short a put option? Let the underlying asset price at maturity be ##S_T##, the exercise price be ##X_T## and the option price be ##f_{LP,0}##. Note that ##S_T##, ##X_T## and ##f_{LP,0}## are all positive numbers.
A trader sells one crude oil European style call option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:
A trader buys one crude oil European style put option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:
A trader just bought a European style put option on CBA stock. The current option premium is $2, the exercise price is $75, the option matures in one year and the spot CBA stock price is $74.
Which of the following statements is NOT correct?
Question 584 option, option payoff at maturity, option profit
Which of the following statements about European call options on non-dividend paying stocks is NOT correct?
A company runs a number of slaughterhouses which supply hamburger meat to McDonalds. The company is afraid that live cattle prices will increase over the next year, even though there is widespread belief in the market that they will be stable. What can the company do to hedge against the risk of increasing live cattle prices? Which statement(s) are correct?
(i) buy call options on live cattle.
(ii) buy put options on live cattle.
(iii) sell call options on live cattle.
Select the most correct response:
Below are 4 option graphs. Note that the y-axis is payoff at maturity (T). What options do they depict? List them in the order that they are numbered.
You have just sold an 'in the money' 6 month European put option on the mining company BHP at an exercise price of $40 for a premium of $3.
Which of the following statements best describes your situation?
You operate a cattle farm that supplies hamburger meat to the big fast food chains. You buy a lot of grain to feed your cattle, and you sell the fully grown cattle on the livestock market.
You're afraid of adverse movements in grain and livestock prices. What options should you buy to hedge your exposures in the grain and cattle livestock markets?
Select the most correct response:
Being long a call and short a put which have the same exercise prices and underlying stock is equivalent to being:
A stock, a call, a put and a bond are available to trade. The call and put options' underlying asset is the stock they and have the same strike prices, ##K_T##.
Being long the call and short the stock is equivalent to being:
A one year European-style call option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at $5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 ##(u = 1.6)## or fall to $3.125 ##(d = 1/1.6)## in one year. The call option price now is:
A one year European-style put option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at $5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 ##(u = 1.6)## or fall to $3.125 ##(d = 1/1.6)## in one year. The put option price now is:
A 12 month European-style call option with a strike price of $11 is written on a dividend paying stock currently trading at $10. The dividend is paid annually and the next dividend is expected to be $0.40, paid in 9 months. The risk-free interest rate is 5% pa continuously compounded and the standard deviation of the stock’s continuously compounded returns is 30 percentage points pa. The stock's continuously compounded returns are normally distributed. Using the Black-Scholes-Merton option valuation model, determine which of the following statements is NOT correct.
A one year European-style call option has a strike price of $4.
The option's underlying stock currently trades at $5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.
The risk-free interest rate is 10% pa continuously compounded.
Use the Black-Scholes-Merton formula to calculate the option price. The call option price now is:
A one year European-style put option has a strike price of $4.
The option's underlying stock currently trades at $5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.
The risk-free interest rate is 10% pa continuously compounded.
Use the Black-Scholes-Merton formula to calculate the option price. The put option price now is:
Question 794 option, Black-Scholes-Merton option pricing, option delta, no explanation
Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the Delta of a European call option?
Where:
###d_1=\dfrac{\ln[S_0/K]+(r+\sigma^2/2).T)}{\sigma.\sqrt{T}}### ###d_2=d_1-\sigma.\sqrt{T}=\dfrac{\ln[S_0/K]+(r-\sigma^2/2).T)}{\sigma.\sqrt{T}}###Question 795 option, Black-Scholes-Merton option pricing, option delta, no explanation
Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the Delta of a European put option?
Question 796 option, Black-Scholes-Merton option pricing, option delta, no explanation
Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the risk-neutral probability that a European call option will be exercised?
Question 385 Merton model of corporate debt, real option, option
A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:
##V## = Market value of assets.
##E## = Market value of (levered) equity.
##D## = Market value of zero coupon bonds.
##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.
The levered equity graph above contains bold labels a to e. Which of the following statements about those labels is NOT correct?
Question 386 Merton model of corporate debt, real option, option
A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:
##V## = Market value of assets.
##E## = Market value of (levered) equity.
##D## = Market value of zero coupon bonds.
##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.
The risky corporate debt graph above contains bold labels a to e. Which of the following statements about those labels is NOT correct?
Question 382 Merton model of corporate debt, real option, option
In the Merton model of corporate debt, buying a levered company's shares is equivalent to:
Question 383 Merton model of corporate debt, real option, option
In the Merton model of corporate debt, buying a levered company's debt is equivalent to buying the company's assets and:
Which of the following is the least useful method or model to calculate the value of a real option in a project?
One of the reasons why firms may not begin projects with relatively small positive net present values (NPV's) is because they wish to maximise the value of their:
A moped is a bicycle with pedals and a little motor that can be switched on to assist the rider. Mopeds are useful for quick transport using the motor, and for physical exercise when using the pedals unassisted. This offers the rider:
You're thinking of starting a new cafe business, but you're not sure if it will be profitable.
You have to decide what type of cups, mugs and glasses you wish to buy. You can pay to have your cafe's name printed on them, or just buy the plain un-marked ones. For marketing reasons it's better to have the cafe name printed. But the plain un-marked cups, mugs and glasses maximise your:
Some financially minded people insist on a prenuptial agreement before committing to marry their partner. This agreement states how the couple's assets should be divided in case they divorce. Prenuptial agreements are designed to give the richer partner more of the couples' assets if they divorce, thus maximising the richer partner's:
The cheapest mobile phones available tend to be those that are 'locked' into a cell phone operator's network. Locked phones can not be used with other cell phone operators' networks.
Locked mobile phones are cheaper than unlocked phones because the locked-in network operator helps create a monopoly by:
Question 433 Merton model of corporate debt, real option, option, no explanation
A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:
##V## = Market value of assets.
##E## = Market value of (levered) equity.
##D## = Market value of zero coupon bonds.
##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.
What is the payoff to equity holders at maturity, assuming that they keep their shares until maturity?
Question 434 Merton model of corporate debt, real option, option
A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:
##V## = Market value of assets.
##E## = Market value of (levered) equity.
##D## = Market value of zero coupon bonds.
##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.
What is the payoff to debt holders at maturity, assuming that they keep their debt until maturity?
Question 397 financial distress, leverage, capital structure, NPV
A levered firm has a market value of assets of $10m. Its debt is all comprised of zero-coupon bonds which mature in one year and have a combined face value of $9.9m.
Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.
Therefore the current market capitalisation of debt ##(D_0)## is $9m and equity ##(E_0)## is $1m.
A new project presents itself which requires an investment of $2m and will provide a:
- $6.6m cash flow with probability 0.5 in the good state of the world, and a
- -$4.4m (notice the negative sign) cash flow with probability 0.5 in the bad state of the world.
The project can be funded using the company's excess cash, no debt or equity raisings are required.
What would be the new market capitalisation of equity ##(E_\text{0, with project})## if shareholders vote to proceed with the project, and therefore should shareholders proceed with the project?
Question 278 inflation, real and nominal returns and cash flows
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year.
Question 992 inflation, real and nominal returns and cash flows
You currently have $100 in the bank which pays a 10% pa interest rate.
Oranges currently cost $1 each at the shop and inflation is 5% pa which is the expected growth rate in the orange price.
This information is summarised in the table below, with some parts missing that correspond to the answer options. All rates are given as effective annual rates. Note that when payments are not specified as real, as in this question, they're conventionally assumed to be nominal.
| Wealth in Dollars and Oranges | ||||
| Time (year) | Bank account wealth ($) | Orange price ($) | Wealth in oranges | |
| 0 | 100 | 1 | 100 | |
| 1 | 110 | 1.05 | (a) | |
| 2 | (b) | (c) | (d) | |
Which of the following statements is NOT correct? Your: