Exam 2 - Spring 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.

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       .25        - 5%        12%       7%
     Fair      .40         12%         7%       7%
     Good      .35         18%         2%       7%
    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: [15 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 12%. According to portfolio theory, describe the best (most rational) method of constructing such a portfolio and justify your strategy based on the underlying theory.

    
[5]  Wt in A: _______   Wt. in B: ________   Wt. in T-Bills: _______


[3]  Justification:
    c. Suppose you plan to invest $34000 in Asset A and $25000 in Asset B. What will be the expected return, standard deviation, and beta coefficient of your portfolio?

      [3] Expected Rate of Return: _________________

      [3] Standard Deviation of Return: _____________

      [3] Beta Coefficient: ____________________


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

2. Answer the following questions CLEARLY and CONCISELY (don't BS):

[5] Why is the total risk of a stock or other investment irrelevant in an investor's assessment of required return? Doesn't risk matter to this decision?

[5] Explain what sorts of factors influence the slope of the security market line and discuss the specific direction of the effect.

[5] Explain what sorts of factors influence the height of the security market line and discuss the specific direction of the effect.

3. The We-B-GR8 Co. is considering expanding its production of one product by replacing an existing production line with a newer and larger one. The existing equipment was purchased one year ago for $187,500. It is being depreciated over a total of 5 years to a zero book value using straightline depreciation. This equipment has a current market value of $130,000 and requires $15,000 in net working capital consisting of tools, parts, and related items. If this equipment is used for three more years, it is expected to have a market value of $20,000 at the end of that time. It is expected to generate annual revenue of $155,000 and annual cash expenses of $110,000.

The proposed new equipment has an installed cost of $225,000 and will be depreciated by 3-year ACRS-class rules using these percentages (.3334 in the first year, .4444 in the second year, .1481 in the third year) over the THREE years that the line will be used. The new equipment will require a fixed investment of $35,000 in net working capital. It is expected to generate annual revenue of $260,000 and annual cash expenses of $125,000. If this equipment is used for three more years, it is expected to have a market value of $100,000 at the end of that time.

The installation of the new equipment will require an unrelated production line to be moved to another location in the factory since the new equipment will require more space than the old equipment. This relocation of the unrelated line will incur $50,000 in expenses. Also, structural repairs to the area that will be occupied by the new equipment will be carried out at the time that the new line is installed. These repairs include roof repairs and electrical modifications that are required by the government in order to conform to safety standards. These repairs and modification will cost $85,000.

The company's marginal tax rate is 40%. The appropriate discount rate is 12.5%. Answer the following questions. Show all relevant work in the space provided here. LABEL EVERYTHING CLEARLY.


     a.   Net Cash Outlay at t=0: $_______________ [4]

     b.   Net Cash Flow at t=1: $_________________ [15 Total]
  
          Net Cash Flow at t=2: $_________________ 
 
          Net Cash Flow at t=3: $_________________ 



     Based on your answers above, determine:

     c.  Net Present Value:  $________________ [5]


     d.  Internal Rate of Return (within 1.0%): _____________ [5]


     e.   MIRR: $______________ [5]


     f.   Equivalent Annual Annuity [5]
3. Name and explain at least two advantages of MIRR over IRR. Be specific but concise. [6]

4. In class, we talked about four (4) methods to include a consideration of risk in the capital budgeting decision framework. Briefly describe each of the four and give a brief comparison of the advantages and disadvantages of each. [15]

Answers

Question 1: 

            ASSET                   A         B       T-Bills


     Expected Return               9.85      6.50       7.0

     Standard Dev. of Return       8.96      3.84        0

     Correlation with Asset A               -.954        0

     Correlation with T-Bills       0          0

     Beta Coefficient               1       -.409        0


     b.   1.7544       0       -.7544
	 
	 c.    8.43%      3.64%     4.029%
Question 2:

    CF(0) = -157,000
    CF(1) = 69,006
    CF(2) = 78,996
    CF(3) = 111,998

    c. 45,415
    d. 27.40%
    e. 22.44%
    f. 19,071



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