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Fundamentals of corporate finance 2nd Edition Robert Parrino, David S. Kidwell, Thomas W. Bates - Solutions
The top prize for the state lottery is $100,000,000. You have decided it is time for you to take a chance and purchase a ticket. Before you purchase the ticket, you must decide whether to choose the cash option or the annual payment option. If you choose the annual payment option and win, you will
At what interest rate would you be indifferent between the cash and annual payment options in Problem 6.36?
Babu Baradwaj is saving for his son’s college tuition. His son is currently 11 years old and will begin college in seven years. Babu has an index fund investment worth $7,500 that is earning 9.5 percent annually. Total expenses at the University of Maryland, where his son says he plans to go,
You are now 50 years old and plan to retire at age 65. You currently have a stock portfolio worth $150,000, a 401(k) retirement plan worth $250,000, and a money market account worth $50,000. Your stock portfolio is expected to provide annual returns of 12 percent, your 401(k) investment will earn
Trevor Diaz is looking to purchase a Mercedes Benz SL600 Roadster, which has an invoice price of $121,737 and a total cost of $129,482. Trevor plans to put down $20,000 and will pay the rest by taking on a 5.75 percent five-year bank loan. What is the monthly payment on this auto loan? Prepare an
The Sundarams are buying a new 3,500-square-foot house in Muncie, Indiana, and will borrow $237,000 from Bank One at a rate of 6.375 percent for 15 years. What will be their monthly loan payment? Prepare an amortization schedule using Excel.
Assume you will start working as soon as you graduate from college. You plan to start saving for your retirement on your 25th birthday and retire on your 65th birthday. Aft er retirement, you expect to live at least until you are 85. You wish to be able to withdraw $40,000 (in today’s dollars)
Groves Corp. is expecting annual cash flows of $225,000, $278,000, $312,500, and $410,000 over the next four years. If it uses a discount rate of 6.25 percent, what is the present value of this cash flow stream?
Freisinger, Inc., is expecting a new project to start paying off , beginning at the end of next year. It expects cash flows to be as follows:If Freisinger can reinvest these cash flows to earn a return of 7.8 percent, what is the future value of this cash flow stream at the end of fiveyears?
Sochi, Russia is the site of the next Winter Olympics in 2014. City officials plan to build a new multipurpose stadium. The projected cost of the stadium in 2014 dollars is $7.5 million. Assume that it is the end of 2011 and city officials intend to invest an equal amount of money at the end of
You have just won a lottery that promises an annual payment of $118,312 beginning immediately. You will receive a total of 10 payments. If you can invest the cash flows in an investment paying 7.65 percent annually, what is the present value of this annuity?
Which of the following investments has the highest effective annual interest rate (EAR)?a. A bank CD that pays 5.50 percent compounded quarterly.b. A bank CD that pays 5.45 percent compounded monthly.c. A bank CD that pays 5.65 percent compounded annually.d. A bank CD that pays 5.55 percent
What are the two components of a total holding period return?
How is the expected return on an investment calculated?
What is the relation between the variance and the standard deviation?
What relation do we generally observe between risk and return when we examine historical returns?
How would we expect the standard deviation of the return on an individual stock to compare with the standard deviation of the return on a stock index?
What does the coefficient of variation tell us, and how is it related to the Sharpe Ratio?
What are the two components of total risk?
Why does the total risk of a portfolio not approach zero as the number of assets in a portfolio becomes very large?
Why are returns on the stock market used as a benchmark in measuring systematic risk?
How is beta estimated?
How would you interpret a beta of 1.5 for an asset? A beta of 0.75?
How is the expected return on an asset related to its systematic risk?
What name is given to the relation between risk and expected return implied by the CAPM?
If an asset’s expected return does not plot on the line in question 2 above, what does that imply about its price?
Given that you know the risk as well as the expected return for two stocks, discuss what process you might utilize to determine which of the two stocks is a better buy. You may assume that the two stocks will be the only assets held in your portfolio.
What is the difference between the expected rate of return and the required rate of return? What does it mean if they are different for a particular asset at a particular point in time?
Suppose that the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these two stocks? How might the required rate of return on the stock of a third company be greater than the
The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is 0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want your portfolio to have the lowest possible risk, would you buy stock B or C? Would you expect the stock you
The idea that we can know the return on a security for each possible outcome is overly simplistic. However, even though we cannot possibly predict all possible outcomes, this fact has little bearing on the risk-free return. Explain why.
Which investment category has shown the greatest degree of risk in the United States since 1926? Explain why that makes sense in a world where the value of an asset in this investment category is likely to be more adversely affected by a particular negative event than the price of a corporate bond.
You are concerned about one of the investments in your fully diversified portfolio. You just have an uneasy feeling about the CFO, Iam Shift y, of that particular firm. You do believe, however, that the firm makes a good product and that it is appropriately priced by the market. Should you be
The CAPM is used to price the risk in any asset. Our examples have focused on stocks, but we could also price the expected rate of return for bonds. Explain how debt securities are also subject to systematic risk.
In recent years, investors have correctly agreed that the market portfolio consists of more than just a group of U.S. stocks and bonds. If you are an investor who invests in only U.S. stocks, describe the effects on the risk in your portfolio.
You may have heard the statement that you should not include your home as an asset in your investment portfolio. Assume that your house will comprise up to 75 percent of your assets in the early part of your investment life. Evaluate the implications of omitting it from your portfolio when
Describe the difference between a total holding period return and an expected return.
John is watching an old game show rerun on television called Let’s Make a Deal in which the contestant chooses a prize behind one of two curtains. Behind one of the curtains is a gag prize worth $150, and behind the other is a round-the-world trip worth $7,200. The game show has placed a
You have chosen biology as your college major because you would like to be a medical doctor. However, you find that the probability of being accepted to medical school is about 10 percent. If you are accepted to medical school, then your starting salary when you graduate will be $300,000 per year.
Describe the general relation between risk and return that we observe in the historical bond and stock market data.
Stocks A, B, and C have expected returns of 15 percent, 15 percent, and 12 percent, respectively, while their standard deviations are 45 percent, 30 percent, and 30 percent, respectively. If you were considering the purchase of each of these stocks as the only holding in your portfolio and the
Describe how investing in more than one asset can reduce risk through diversification.
Define systematic risk.
Susan is expecting the returns on the market portfolio to be negative in the near term. Since she is managing a stock mutual fund, she must remain invested in a portfolio of stocks. However, she is allowed to adjust the beta of her portfolio. What kind of beta would you recommend for Susan’s
Describe and justify what the value of the beta of a U.S. Treasury bill should be.
If the expected rate of return for the market is not much greater than the risk-free rate of return, what is the general level of compensation for bearing systematic risk?
Describe the Capital Asset Pricing Model (CAPM) and what it tells us.
If the expected return on the market is 10 percent and the risk-free rate is 4 percent, what is the expected return for a stock with a beta equal to 1.5? What is the market risk premium for the set of circumstances described?
Jose is thinking about purchasing a soft drink machine and placing it in a business office. He knows that there is a 5 percent probability that someone who walks by the machine will make a purchase from the machine, and he knows that the profit on each soft drink sold is $0.10. If Jose expects a
The distribution of grades in an introductory finance class is normally distributed, with an expected grade of 75. If the standard deviation of grades is 7, in what range would you expect 95 percent of the grades to fall?
Kate recently invested in real estate with the intention of selling the property one year from today. She has modeled the returns on that investment based on three economic scenarios. She believes that if the economy stays healthy, then her investment will generate a 30 percent return. However, if
Barbara is considering investing in a stock and is aware that the return on that investment is particularly sensitive to how the economy is performing. Her analysis suggests that four states of the economy can affect the return on the investment. Using the table of returns and probabilities below,
Ben would like to invest in gold and is aware that the returns on such an investment can be quite volatile. Use the following table of states, probabilities, and returns to determine the expected return and the standard deviation of the return on Ben€™s gold investment.
Using the information from Problems 7.15, 7.16, and 7.17, calculate the coefficient of variation for each of the investments in those problems.
Emmy is analyzing a two-stock portfolio that consists of a Utility stock and a Commodity stock. She knows that the return on the Utility stock has a standard deviation of 40 percent and the return on the Commodity stock has a standard deviation of 30 percent. However, she does not know the exact
Given the returns and probabilities for the three possible states listed below, calculate the covariance between the returns of Stock A and Stock B. For convenience, assume that the expected returns of Stock A and Stock B are 11.75 percent and 18 percent, respectively.
You have constructed a diversified portfolio of stocks such that there is no unsystematic risk. Explain why the expected return of that portfolio should be greater than the expected return of a risk-free security.
Write out the equation for the covariance in the returns of two assets, Asset 1 and Asset 2. Using that equation, explain the easiest way for the two asset returns to have a covariance of zero.
Evaluate the following statement: By fully diversifying a portfolio, such as by buying every asset in the market, we can completely eliminate all types of risk, thereby creating a synthetic Treasury bill.
Damien knows that the beta of his portfolio is equal to 1, but he does not know the risk-free rate of return or the market risk premium. He also knows that the expected return on the market is 8 percent. What is the expected return on Damien’s portfolio?
In February 2011 the risk-free rate was 4.75 percent, the market risk premium was 6 percent, and the beta for Dell stock was 1.31. What is the expected return that was consistent with the systematic risk associated with the returns on Dell stock?
The market risk premium is 6 percent, and the risk-free rate is 5 percent. If the expected return on a bond is 6.5 percent, what is its beta?
David is going to purchase two stocks to form the initial holdings in his portfolio. Iron stock has an expected return of 15 percent, while Copper stock has an expected return of 20 percent. If David plans to invest 30 percent of his funds in Iron and the remainder in Copper, then what will be
Sumeet knows that the covariance in the return on two assets is –0.0025. Without knowing the expected return of the two assets, explain what that covariance means.
In order to fund her retirement, Glenda requires a portfolio with an expected return of 12 percent per year over the next 30 years. She has decided to invest in Stocks 1, 2, and 3, with 25 percent in Stock 1, 50 percent in Stock 2, and 25 percent in Stock3. If Stocks 1 and 2 have expected returns
Tonalli is putting together a portfolio of 10 stocks in equal proportions. What is the relative importance of the variance for each stock versus the covariance for the pairs of stocks? For this exercise, ignore the actual values of the variance and covariance terms and explain their importance
Explain why investors who have diversified their portfolios will determine the price and, consequently, the expected return on an asset.
Brad is about to purchase an additional asset for his well-diversified portfolio. He notices that when he plots the historical returns of the asset against those of the market portfolio, the line of best fit tends to have a large amount of prediction error for each data point (the scatter plot is
The beta of an asset is equal to 0. Discuss what the asset must be.
The expected return on the market portfolio is 15 percent, and the return on the risk-free security is 5 percent. What is the expected return on a portfolio with a beta equal to 0.5?
Draw the Security Market Line (SML) for the case where the market risk premium is 5 percent and the risk-free rate is 7 percent. Now suppose an asset has a beta of –1.0 and an expected return of 4 percent. Plot it on your graph. Is the security properly priced? If not, explain what we might
If the CAPM describes the relation between systematic risk and expected returns, can both an individual asset and the market portfolio of all risky assets have negative expected real rates of return? Why or why not?
You have been provided the following data on the securities of three firms and the market:Assume the CAPM and SML are true and fill in the missing values in the table. Would you invest in the stock of any of the three firms? If so, which one(s) andwhy?
Friendly Airlines stock is selling at a current price of $37.50 per share. If the stock does not pay a dividend and has a 12 percent expected return, what is the expected price of the stock one year from today?
Stefan’s parents are about to invest their nest egg in a stock that he has estimated to have an expected return of 9 percent over the next year. If the return on the stock is normally distributed with a 3 percent standard deviation, in what range will the stock return fall 95 percent of the time?
Elaine has narrowed her investment alternatives to two stocks (at this time she is not worried about diversifying): Stock M, which has a 23 percent expected return, and Stock Y, which has an 8 percent expected return. If Elaine requires a 16 percent return on her total investment, then what
You have just prepared a graph similar to Exhibit 7.9, comparing historical data for Pear Computer Corp. and the general market. When you plot the line of best fit for these data, you find that the slope of that line is 2.5. If you know that the market generated a return of 12 percent and that the
The CAPM predicts that the return of MoonBucks Tea Corp. is 23.6 percent. If the risk-free rate of return is 8 percent and the expected return on the market is 20 percent, then what is MoonBucks’ beta?
What are the main differences between the bond markets and stock markets?
A bond has a 7 percent coupon rate, a face value of $1,000, and a maturity of four years. On a time line, lay out the cash flows for the bond.
Explain what a convertible bond is.
Explain conceptually how bonds are priced.
What is the compounding period for most bonds sold in the United States?
What are zero coupon bonds, and how are they priced?
Explain how bond yields are calculated.
What is interest rate risk?
Explain why long-term bonds with zero coupons are riskier than short-term bonds that pay coupon interest.
What are default risk premiums, and what do they measure?
Describe the three most prominent bond rating systems.
What are the key factors that most affect the level and shape of the yield curve?
Because the conversion feature in a convertible bond is valuable to bondholders, convertible bond issues have lower coupon payments than otherwise similar bonds that are not convertible. Does this mean that a company can lower its cost of borrowing by selling convertible debt? Explain.
What economic conditions would prompt investors to take advantage of a bond’s convertibility feature?
We know that a vanilla bond that has a coupon rate which is below the market rate of interest will sell for a discount and that a vanilla bond which has a coupon rate above the market rate of interest will sell for a premium. What kind of bond or loan will sell at its par value regardless of what
Define yield to maturity. Why is it important?
Define interest rate risk. How can CFOs manage this risk?
Explain why bond prices and interest rates are negatively related. What is the role of the coupon rate and term to maturity in this relation?
If interest rates are expected to increase, should investors look to long-term bonds or short-term securities? Explain.
Explain what you would assume the yield curve would look like during economic expansion and why.
An investor holds a 10-year bond paying a coupon of 9 percent. The yield to maturity of the bond is 7.8 percent. Would you expect the investor to be holding a par-value, premium, or discount bond? What if the yield to maturity were 10.2 percent? Explain.
a. Investor A holds a 10-year bond, while investor B holds an 8-year bond. If the interest rate increases by 1 percent, which investor has the higher interest rate risk? Explain.b. Investor A holds a 10-year bond paying 8 percent a year, while investor B also has a 10-year bond that pays a 6
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