FINANCE 634 EXAM 2
Fall 1995

You must show enough work to justify your answer in the space provided with each problem. No credit will be given unless work is shown. Partial credit may be given ONLY IF your work is clearly labeled. Responses to essay questions should be CLEARLY WRITTEN, CONCISE, and WELL-FOCUSED. Be sure to read all questions carefully and answer them completely. Points are as marked. Points do not sum to 100.

1. You have estimated the following subjective distributions of returns for the assets shown for the coming year in three possible states of the economy.


                                                        RETURNS                                          
           Economy      Prob.            A           B         T-Bills 

             Bad          .15           -3%          3%           6%
             Fair         .40           10%          7%           6%
             Good         .45           20%         17%           6%
    Asset A is a well-diversified portfolio composed of 100 stocks. Asset B is a portfolio of a few risky investments.

    a. Complete the following table: [20 Pts. -5 Points for each wrong or absent answer -- Zero minimum]

    

       ASSET-->                              A              B         T-Bills

       Expected Return                       ?              ?            ?

       Standard Dev. of Return               ?              ?            ?

       Correlation with Asset A                             ?            ?

       Correlation with T-Bills              ?              ?       

       Beta Coefficient                      ?              ?            ?
    b. Suppose you want to form a portfolio from any or all of the assets listed above such that your expected return is 18%. According to portfolio theory, describe the best (most rational) method of constructing such a portfolio and justify (in words) your strategy based on the underlying theory.

      [5] Wt in A: _________ Wt. in B: ___________ Wt. in T-Bills: __________

      [5] Justification:

    c. Suppose you plan to invest $29,925 in Asset B and $55,575 in Asset A. What will be the expected return, standard deviation, and beta coefficient of your portfolio?

      [5] Expected Rate of Return: _________________

      [5] Standard Deviation of Return: _____________

      [5] Beta Coefficient: ____________________

    d. According to portfolio theory, is the investment described in part c rational? Why or why not? (Be specific and make appropriate references to the underlying theory.) [5]

    e. According to portfolio theory, what would be the buy or sell decision for Asset B? Support your answer with appropriate references to the theory.[5]

2. Explain the difference between ex post and ex ante information. [2]

3. You are considering two investments, A and B. Investment A costs $100,000 and its expected payoff at the end of the year is $114,000. The variance ( 2) of its rate of return is 25%. Investment B costs $50,000 and its expected payoff at the end of the year is $56,000. The variance of its rate of return is also 25%. The expected rate of return on the market portfolio is 14% and its variance is 16%. The market yield on riskless bonds is 9%. Using capital market theory, which is the superior investment? [5]

4. Suppose a company's management used a single discount rate to compute the NPV of all of its potential investment projects even though the projects had a wide range of nondiversifiable risk. Suppose that the firm then undertook all of the projects that were determined to have positive NPV's. Is this an appropriate manner in which to select investment projects? Why or why not? What will the effect be on the firm if this method of selecting investments is continued over long time period? Be brief and very specific.[5]

[5]
NOTE: The main capital budgeting problem on this test was a very bad problem. It has been deleted to preserve your (and my) sanity.

5. The ABD Corporation is considering the replacement of a machine used for inventory storage. Machine A costs $49,000 to purchase, it has a 5-year useful life, and it will be depreciated over 5 years on a straight-line basis to a book value of $4,000 at the end of the fifth year at which time it is expected to have a salvage value of $10,000. At the expected level of production, the machine will cost $25,000 per year to operate. Machine B has a 10-year useful life but costs $75,000 to purchase. It will be depreciated over 8 years on a straight-line basis to a book value of zero. This machine will require an overhaul at the end of year 6, which will cost $18,000. This cost will be expensed rather than capitalized. At the end of the 10th year, Machine B is expected to have no salvage value. Annual operating expenses for this machine are expected to be $24,000. Its capacity is equal to that of Machine A. The marginal tax rate for the company is 40% and the appropriate discount rate is 12%. Which machine should be purchased and why? [10]

Answers

 Question 1:

       ASSET-->                              A            B        T-Bills

       Expected Return                     12.55%       10.90%      6.0%

       Standard Dev. of Return               7.99%       5.67%       0

       Correlation with Asset A                           .945       0

       Correlation with T-Bills                0            0       

       Beta Coefficient                        1         .67121      0
    B. Wt in A = 0 , Wt. in B = 2.45, Wt. in T-Bills = -1.45

    C. Expected Return = 11.973%, SD = 7.101%, Beta = .885

    E. Asset B is undervalued (it plots above the SML) so it should be bought.

Question 3:

    You can't say until you know the Beta of the portfolio.

Question 5:

Using the Equivalent Annual Annuity (EAA) approach, the 5-year asset has a lower annual cost than the 10-year asset. Using the replacement chain method, the 5-year asset has a lower present value of costs than the 10-year asset (after putting the 5-year asset on a 10-year time line).
      NPV of 5-year asset = -134,457 over 10 years (-85,782 over 5 years)
      NPV of 10-year asset = -143,206
      EAA of 5-year asset = -23,797
      EAA of 10-year asset = -25,345