# Decide to Decide

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```					  BM410: Investments

Assessment Exam #2:
Review Problems
Preparing for the 2nd Assessment Exam

 How to do well on my exams (by order of
what I think is most important):
• 1. Review the PowerPoints for each class
• These are the things I consider important
• Especially look for application problems
and know how to do them
• 2. Review the previous quizzes and exams
• 3. Review the homework problems and readings
• Think through the purpose for each problem
Problem 1: Economic Analysis

What monetary and fiscal policies might
be prescribed for an economy in a deep
recession?

Expansionary (i.e., looser) monetary
policy to lower interest rates would help
to stimulate investment and expenditures
on consumer durables.
Expansionary fiscal policy (i.e., lower
taxes, higher government spending,
increased welfare transfers) would
directly stimulate aggregate demand.
Problem 2: Industry Analysis

 In which stage of the industry life cycle would
you place the following industries. Note that
there is often considerable room for
to this question (use start-up, consolidation,
maturity, and decline as your major stages).
• A. Oil well equipment
• B. Computer hardware
• C. computer software
• D. Genetic engineering

 a. Oil well equipment.
• Possible decline worldwide, due to environmental
pressures and a decline in easily-developed oil
fields, but may be in maturity in the US due to
increased need for energy
 b. Computer hardware
• Generally a consolidation or maturity stage
 c. Computer software
• Likely in a consolidation stage currently
 d. Genetic engineering
• Likely in a start-up stage
Problem 3: Equity Valuation

A common stock pays an annual
dividend per share of \$2.10. The risk-
free rate is 7% and the risk premium for
this stock is 4%. If the annual dividend
is expected to remain at \$2.10, what is
the value of the stock?

If the risk premium on the stock is 4%,
and the risk-free rate is 7%, then the
require rate on the stock would be 11%.
Given a forecast dividend of \$2.10,
divide that by your 11% discount rate to
give a price of = \$19.09
Problem 4: Financial Statement Analysis

 An analyst applies the DuPont system of
financial analysis to the following data for a
company:
• Leverage ratio                    2.2
• Total Asset turnover              2.0
• Net Profit Margin                 5.5%
• Dividend payout ratio             31.8%
 What is the company’s return on equity?

 The goal is to get earnings over equity.
• Leverage is Assets/Equity
• Asset turnover is Sales/Assets
• Profit Margin is Earnings/Sales
• Payout ratio is Dividends/Earnings
 If we take:
• Earnings/S * S/A * A/Equity, the Sales and Assets
cancel to give Earnings over Equity. Numerically,
it is:
• 5.5%  2.0  2.2 = 24.2%
Problem 5: Taxes

You are choosing a fund that you will put in your investment
(non-retirement) account. Assuming distribution and
operating activities which occurred in the past will likely
continue, which of the following funds should you include
in your taxable (non-retirement) account. Assume federal
taxes on short term distributions are 35% and state taxes are
7%. How would this change if these were both stock funds?
Mutual Funds                  Fund A          Fund B
Beginning NAV              \$10.00           \$10.00
YTD Nominal returns        10%                  10%
Estimated Turnover         10%                    90%
Short-term distributions .10                     .90
Ending NAV                 10.90              10.10

Mutual Funds                Fund A         Fund B
Beginning NAV            \$10.00          \$10.00
Short-term distributions .10                  .90
Ending NAV                10.90           10.10
Tax on ST distributions 35%+7%            35%+7%
Taxes paid (w/o selling) .042               .378
After-tax return            9.58%          6.22%
Loss from return due to taxes .42%               3.78%
Although both have the same before-tax return, fund B
had a 35% lower return due to taxes. Fund A is the
better choice for a taxable account, while either fund
could be used for a retirement account
Problem 6: Stock Performance

Last year you purchased 100 shares of MAM
Corporation for \$40 per share. Over the past
12 months MAM’s share price has gone up to
\$45 per share, and you received a dividend of
\$1 per share. What was your total rate of
return on your investment in MAM stock?

You can do this problem two ways.
• First, total payout.
• ((\$4,500-\$4,000) + 100) / \$4,000 = ?
• 15%
• Or, share amount
• (\$45 – 40) + 1 / 40 = ?
• 15%
Problem 7: Stock Performance

Your investment in MAM stock was so
successful that you decided to hold it for 5
more years. Remember, you purchased 100
shares for \$40 per share. Unfortunately, the
price of MAM stock has not risen; it is back to
where you purchased it. The good news is that
you earned \$1 per share for five years.
Calculate your annualized total rate of return.
Compared to a bank account earning 2% APY,

The easy way:
• \$1/\$40 = 2.50%
• Or
• [1+((\$4,000-\$4,000) + 500) / \$4,000)](1/5) =
2.38%

• The stock performed better than the bank
account
Problem 8: Retirement Planning

• Andrew and Suzy recently reviewed their future
retirement income and expense projection. They hope
to retire in 30 years. They determined that they would
need an annual retirement income of \$80,000 in
today’s dollars, but they currently only have \$25,000
annually with expected Social Security and savings.
• Calculate the total amount that Andrew and Suzy
must save for retirement if they wish to meet their
income projection, assuming a 3% inflation rate
before retirement and 2% after, and an 8% return
before retirement and 6% after retirement. They
believe they will be in retirement for 25 years.

 First, draw the diagram
1. Calculate the Shortfall
3. Calculate the real return and the annuity
4. Calculate the period payment
Time           30 years                  25 years

Return        8%           Return       6%
Inflation     3%           Inflation    2%

Now                      Retirement                 Death

 1. The annual shortfall is: 80,000 – 25,000 = ?
• The shortfall is \$55,000.
 2. To get the inflation adjusted amount, we use: PV = -
55,000, I/Y = 3, N = 30, and solve for FV which gives
the amount that they need annually in retirement.
• FV of \$133,499

 3. To get the real return and the annuity for 25 years,
calculate the real return with 6% nominal and 2%
inflation, which gives a real return of ?
• Real return of 3.92% = [(1.06)/(1.02)] – 1.
 The annuity required is PMT = \$133,499, I = 3.92, N =
25, PV = ?
• The annuity needed is \$2,103,279
 4. to get the amount to save, it is I = 8%, N = 30, FV =
\$2,103,279, and PMT = ? To give what you need to
save each year
• They need to save \$18,567 to reach their goals
financial condition.
Problem 9: International Investing

If the current exchange rate is \$1.75/£,
the one-year forward exchange rate is
\$1.85/£, and the interest rate on British
government bills is 8% per year, what
risk-free dollar-denominated return can
be lock in by investing in the British
bills?

 The formula is: (1 + r(US)) = (1 + r(UK)) 
(F0/E0). (F0/E0) is just 1 + the return from the
currency. To get the US return, solve for:

 = 1.08 * (1.85/1.75) = 1.1417 - 1 = 14.17%

F0 is the forward rate. E0 is the exchange rate

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