INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: MBA-680-50-F12 Corporate Financial Theory

SEMESTER: I, 2012

Coursework 1 - solutions

SECTION A

INSTRUCTIONS

Students are required to complete the following 2 parts. The first part consists of self-test
questions while the second part consists of two exam-type problems. Part 1 counts to 5%
of the final evaluation and Part 2 to 5% of the final evaluation, i.e. the whole coursework
counts towards 10% of the final evaluation. The questions are based on the syllabus and
lectures.

Answers to the Parts 1-2 should be filled in the spaces provided. However, for part 2,
underlying reasoning and calculations showing how you got your answers should also be
attached to the answer sheet in order to make the marking easier.

The deadline for delivering the coursework is October 31st 2012.

This is not a group project. Answers should be your own work and should not involve
collaboration with other students. The policy for suspected plagiarism (copying) is very
severe at the UIA and it may provoke penalties.

Konstantinos Kanellopoulos
October 10th 2012
 SECTION B

PART 1 SELF-TEST QUESTIONS

1. Casino Inc. is expected to pay a dividend of $3 per share at the end of year-1 (D1) and these
dividends are expected to grow at a constant rate of 6% per year forever. If the required rate of
return on the stock is 18%, what is current value of the stock today?
a. $25 CORRECT
b. $50
c. $100
d. $54

2. MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 15%. What is the stable
dividend growth rate for the firm?
a. 9%
b. 5%
c. 6% CORRECT
d. 15%

3. If the discount rate is stated in real terms, then in order to calculate the NPV in a consistent
manner requires that project: I) cash flows be estimated in nominal terms II) cash flows be
estimated in real terms III) accounting income be used: 
a. I only
b. II only CORRECT
c. III only
d. None of the above

4. Proper treatment of inflation in the NPV calculation involves: I) Discounting nominal cash flows
using the nominal discount rate II) Discounting real cash flows using the real discount rate III)
Discounting nominal cash flows using the real discount rates 
a. I only
b. II only
c. III only
d. I and II only CORRECT

5. The cost of a resource that may be relevant to an investment decision even when no cash changes
hand is called a (an): 
a. Sunk cost
b. Opportunity cost CORRECT
c. Working capital
d. None of the above
6. If the average annual rate of return for common stocks is 11.7%, and for treasury bills it is
4.0%, what is the market risk premium? 
a. 15.8%
b. 4.1%
c. 7.7% CORRECT
d. None of the above

7. A statistical measure of the degree to which securities' returns move together is called: 
a. Variance
b. Correlation Coefficient CORRECT
c. Standard Deviation
d. None of the above

8. Investments A and B both offer an expected rate of return of 12%. If the standard deviation of A
is 20% and that of B is 30%, then investors would:
a. Prefer A to B CORRECT
b. Prefer B to A
c. Prefer a portfolio of A and B
d. Cannot answer without knowing investor's risk preferences

9. A stock with a beta of zero would be expected to: 

a. Have a rate of return equal to zero
b. Have a rate of return equal to the market risk premium
c. Have a rate of return equal to the risk-free rate CORRECT
d. Have a rate of return equal to the market rate of return

10. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15% and
that of the market portfolio is 10%, 10% and 16%. According to the security market line (SML),
the Stock A is: 
a. Over priced CORRECT
b. Under priced
c. Correctly priced
d. Need more information
 PART 2 PROBLEM 1
Stephen Oblonsky, ace mutual fund manager, produced the following percentage rates of return from
2002 to 2006. Rates of return on the market are given for comparison.

  2002 2003 2004 2005 2006

Stephen Oglonsky -12,1 28,2 11,0 8,9 15,0
S&P 500 -20,9 31,6 12,5 6,4 15,8

Calculate the average return and standard deviation of Mr. Interchange’s mutual fund. Did he do
better or worse than the market by these measures?

Solution

Stephen Oglonsky Nominal Difference Squared

Return (%) from Difference
Average
2002 -12,1 -22,3 497,29
2003 28,2 18 324,00
2004 11 0,8 0,64
2005 8,9 -1,3 1,69
2006 15 4,8 23,04
       
Total 51   846,66
Average 10,2   211,67
Std. Deviation     14,55

S&P 500 Nominal Difference Squared

Return (%) from Difference
Average
2002 -20,9 -29,98 898,80
2003 31,6 22,52 507,15
2004 12,5 3,42 11,70
2005 6,4 -2,68 7,18
2006 15,8 6,72 45,16
       
Total 45,4   1469,99
Average 9,08   367,50
Std. Deviation     19,17

He would do better with these measures.

PROBLEM 2
 The following table shows standard deviations and correlation coefficients for seven stocks from
different countries.

Deutsche Standard
  Alcan BP Bank Fiat Heineken LVMH Nestle Deviation

Alcan 1,00 0,34 0,53 0,30 0,20 0,53 0,08 29,7%

BP 1,00 0,44 0,26 0,20 0,27 0,29 18,4%

Deutsche Bank 1,00 0,52 0,22 0,56 0,24 30,1%

Fiat 1,00 0,17 0,42 0,26 35,9%

Heineken 1,00 0,33 0,50 17,2%

LVMH 1,00 0,31 31,0%

Nestle             1,00 13,8%

a. Calculate the variance of a portfolio with equal investments in each stock.

b. Your eccentric Aunt Claudia has left you $50,000 in Alcan shares plus $50,000 cash.
Unfortunately her will requires that the Alcan stock not be sold for one year and the $50,000
cash must be entirely invested in one of the stocks shown in the above Table. What is the
safest attainable portfolio under these restrictions?

Solution

a. First find the co-variances between the stocks:

Between Alcan and Alcan: (1/7)2 (0.297)2 = 0.0018
Between Alcan and BP: (1/7)*(1/7) * (0.297) * (0.184) * (0.34) = 0.00379 etc.
In this way, the following table is constructed:
Alcan BP Deutsche Fiat Heineken LVMH Nestle
Alcan 0.0018002 0.0003792 0.0009669 0.0006528 0.0002085 0.0009959 0.0000669
BP 0.0003792 0.0006909 0.0004973 0.0003505 0.0001292 0.0003143 0.0001503
Deutsche 0.0009669 0.0004973 0.0018490 0.0011467 0.0002324 0.0010664 0.0002035
Fiat 0.0006528 0.0003505 0.0011467 0.0026302 0.0002142 0.0009539 0.0002629
Heineken 0.0002085 0.0001292 0.0002324 0.0002142 0.0006038 0.0003591 0.0002422
LVMH 0.0009959 0.0003143 0.0010664 0.0009539 0.0003591 0.0019612 0.0002706
Nestle 0.0000669 0.0001503 0.0002035 0.0002629 0.0002422 0.0002706 0.0003887

The portfolio variance is the sum of all the entries in the matrix. Portfolio variance equals:
0.0292516
b. “Safest” means lowest risk; in a portfolio context, this means lowest variance of return. Half of
the portfolio is invested in Alcan stock, and half of the portfolio must be invested in one of
the other securities listed. Thus, we calculate the portfolio variance for six different
portfolios to see which is the lowest. The safest attainable portfolio is comprised of Alcan
and Nestle.
Stocks Portfolio Variance
BP 0.039806
Deutsche 0.068393
Fiat 0.070266
Heineken 0.034557
LVMH 0.070476
Nestle 0.028453

PROBLEM 3
Phoenix Corp. faltered in the recent recession but has recovered since. EPS and dividends have
grown rapidly since 2014.

  2014 2015 2016 2017 2018

EPS $.75 2.00 2.50 2.60 2.65
Dividends $0 1.00 2.00 2.30 2.65
Dividend growth - - 100% 15% 15%

The figures for 2017 and 2018 are of course dividends. Phoenix’s stock price today in 2016 is
$21.75. Phoenix’s recovery will be complete in 2018, and there will be no further growth in EPS
or dividends.

A security analyst forecasts next year’s rate of return on Phoenix as follows:

DIV 2.30
r   g  0 .15  0 256  25.6%
P0 21.75

What’s wrong with the security analyst’s forecast? What is the actual expected rate of return over
the next year?

Solution

The security analyst’s forecast is wrong because it assumes a perpetual constant growth rate
of 15% when, in fact, growth will continue for two years at this rate and then there will be no
further growth in EPS or dividends.
The value of the company’s stock is the present value of the expected dividend of $2.30 to
be paid in 2017 plus the present value of the perpetuity of $2.65 beginning in 2018.
Therefore, the actual expected rate of return is the solution for r in the following equation:
$2.30 $2.65
$21.75  
1 r r(1  r)
Solving algebraically (using the quadratic formula) or by trial and error, we find that: r =
0.1201= 12.01%