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# Finance Questions

11. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?

Either A or B, i.e., the investor should be indifferent between the two.

Stock A.

Stock B.

Neither A nor B, as neither has a return sufficient to compensate for risk.

Add A, since its beta must be lower.

12. In Japan, 90-day securities have a 4% annualized return and 180-day securities have a 5% annualized return. In the United States, 90-day securities have a 4% annualized return and 180-day securities have an annualized return of 4.5%. All securities are of equal risk, and Japanese securities are denominated in terms of the Japanese yen. Assuming that interest rate parity holds in all markets, which of the following statements is most CORRECT?

The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market.

The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 180-day forward market.

The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market.

The yen-dollar exhange rate in the 180-day forward market equals the yen-dollar exchange rate in the 90-day spot market.

The relationship between spot and forward interest rates cannot be inferred.

13. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 6.80%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

14. Bill Dukes has \$100,000 invested in a 2-stock portfolio. \$75,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?

15. as a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow?

Sales revenues, each year \$40,500
Depreciation \$10,000
Other operating costs \$17,000
Interest expense \$4,000
Tax rate 35.0%

16. To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of \$875, and has a par value of \$1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

17. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?
Equipment cost (depreciable basis) \$70,000
Sales revenues, each year \$41,000
Operating costs (excl. depr.) \$25,000
Tax rate 35.0%

18. Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE?
Assets \$165,000 Interest rate 8%
Debt/Assets, book value 65% Tax rate 40%
EBIT \$25,000

19. Warnock Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.
WACC: 10.00%
Year 0 1 2 3
Cash flows -\$825 \$500 \$400 \$300

20. Harry's Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected.
WACC: 14.75%
Year 0 1 2 3 4 5
Cash flows -\$1,000 \$300 \$300 \$300 \$300 \$300

#### Solution Preview

11.  A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio.  The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market.  Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75.  However, Stock A's standard deviation of returns is 12% versus 8% for Stock B.  Which stock should this investor add to his or her portfolio, or does the choice not matter?
Either A or B, i.e., the investor should be indifferent between the two.
Stock A.
Stock B.
Neither A nor B, as neither has a return sufficient to compensate for risk.
Add A, since its beta must be lower.

Beta of stock = correlation coefficient x standard deviation of stock / standard deviation of market
Since correlation coefficients of A and B are equal but standard deviation of B is lower, Stock B has a lower beta
A stock with a lower beta but same expected return as of another stock is better than the other stock (same return for a lower risk)

12.  In Japan, 90-day securities have a 4% annualized return and 180-day securities have a 5% annualized return.  In the United States, 90-day securities have a 4% annualized return and 180-day securities have an annualized return of 4.5%.  All securities are of equal risk, and Japanese securities are denominated in terms of the Japanese yen.  Assuming that interest rate parity holds in all markets, which of the following statements is most CORRECT?

The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market.
The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 180-day forward market.
The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market.
The yen-dollar exhange rate in the 180-day forward market equals the yen-dollar exchange rate in the 90-day spot market.
The relationship between spot and forward interest rates cannot be inferred.

Answer: The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market.

Difference between 90-day (quarter year) interest rate for Japan and US (annualized)= 0.00% =4%-4%
Thereofre, according to interest rate parity, the spot rate and 90 days forward rates are equal

Difference between 180-day (half year) interest rate for Japan and US (annualized)= 0.50% =5%-4.5%
Thereofre, according to interest rate parity, the 180 days YEN/USD forward rate will be at a premium of 0.5%/2 =0.25% from the YEN/USD spot rate
(Yen will depreciate as it has a higher interest ...

#### Solution Summary

Questions on WACC, NPV, portfolio beta, currency etc. have been solved.

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