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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
     • Check your answers from the net
  • 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

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
  disagreement concerning the “correct” answers
  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
   • E. Railroads

 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
 e. Railroads
     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
    • 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,
 how did your stock do?

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

  • The stock performed better than the bank
       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
       2. Inflation adjust 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
 t your individual level of savings or your current
  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

 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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