Name:
Student ID:
Section:
AP/ADMS 4540 Financial Management
Fall 2018
Mid-term Exam for All Sections
Time Limit: 2 hours
Instructions: Answer all 5 questions of this exam in the spaces provided on the question sheets. (If necessary,
you may write on the back of the sheet). You have 2 hours to work. The marks for each question are given.
Please provide the marker with the greatest opportunity to give you credit by showing all calculations clearly.
Answers without clear calculations will be penalized. Only normal writing instruments, a calculator and one
8.5"x11" or letter-size page list of hand-written formulas may be used to write this test. This formula sheet
must be submitted with the test; otherwise you will automatically receive a mark of zero (0).
Question
No.
Topic
Full Marks
1
Duration and Interest Rates
19
2
Refunding
15
3
ODA
16
4
Risk and Return
30
5
CAPM/APT/Canadian Tradition
20
1
Marks Obtained
Question 1 on Duration and Interest Rates (19 marks)
a) Taylor Swift.is thinking about investing in some bonds. Her investment advisor presents her a $1,000
face value 3-year semi-annual bond with 5.5% coupon per annum and a yield to maturity of 6.7%. What
is the annualised Macaulay duration of the bond? (10 marks)
b) She then considers another bond presented by the investment advisor. This is an 11%, 14-year bond with
a yield to maturity of 12% and a duration of 11.07 years. If the market yield increases by 35 basis points,
how much percentage change will there be in the bond's price? (5 marks)
c) Towards the end of her meeting, as they discuss economic conditions and the bond market, the
investment advisor mentions that inflation is expected to increase. What will be the impact of this on 1)
the supply of bonds 2) the demand for bonds? (4 marks)
Note: One basis point is equivalent to one hundredth of one percent.
2
Question 2 on Refunding (15 marks)
Deep Time Corporation is considering offering a new $110 million bond issue to replace an outstanding $100
million bond issue. The firm wishes to do this to take advantage of the decline in interest rates that has occurred
since the original issue. The two bond issues are described in what follows. The firm is in the 30 percent tax
bracket.
Old bonds. The outstanding bonds have a $1,000 par value and an 8.5 percent coupon interest rate. They were
issued five years ago with a 20-year maturity. They are callable at an 8.5% premium.
New bonds. The new bonds would have a 15-year maturity and a 7.0 percent coupon interest rate. It is expected
that these bonds can be sold at par for a floatation cost of 1% of the total value of the issue.
The firm expects a 3-month period of overlapping interest while it retires the old bonds. The firm can defray
some of the costs by investing the issue at 4 percent, the short-term interest rate. The additional $10 million
from the new bond issue could be invested in a 15-year project with an expected NPV of $2.5 million. Should
Deep Time Corporation refund? (15 marks)
3
Question 3 on ODA (16 marks)
Suppose that the Development Assistance Committee (DAC) of the Organization for Economic Co-operation
and Development (OECD) is considering the following loan for Bangladesh for developing and improving
infrastructure of disaster management in some cyclone-hit area: $15 million, to be amortized over 10 years by
20 semi-annual payments, after a grace period of 5 years during which only interest would be paid semiannually. This loan would charge interest at an annual rate of 7 percent. To qualify as official development
assistance (ODA), development loans must have a grant element of at least 25 percent, calculated using a stated
annual interest rate of 10 percent.
a) Calculate the payments during the grace period and amortization period.
b) Find the present values of these payments at time “zero” using appropriate discount rate.
c) What would the present value be if subsidized rate is used for discounting in part b)?
d) Calculate the grant element for the loan and state whether it qualifies as ODA?
e) How the grant element and subsidized rates are related?
f) Calculate the maximum interest rate for which the loan would still qualify as ODA. Use 6 or 8 percent
of interest rate if required for interpolation.
4
Question 4 on Risk and Return (30 marks)
4a.
From the Youtube videos you watched, explain why does Harry Markowitz not think that market
volatility should prevent one from investing in the stock market, and why does William Sharpe think that
academic finance before the 1960s was “moronic”? (4 marks)
4b.
Zero Beta Fund exploits arbitrage opportunities that other investors miss. Suppose there are many stocks
in the market and that the characteristics of stocks A and B are as follows:
Stock
Expected Return
Standard Deviation
A
0.12
0.08
B
0.09
0.04
Suppose that it is possible to borrow at the risk-free rate and the correlation of stocks A and B is -1. If the riskfree t-bill rate is 9%, could an arbitrage profit be made? How? Note: All returns are annualized and you must
explain your working steps from the equation for portfolio variance to derive the weights of a portfolio in order
to receive full credit. (4 marks)
4c.
Explain the “equity premium puzzle” using historical statistics of the Canadian bond and stock markets.
Explain the “equity premium puzzle” and how it was evident in Canada until the end of the last century and
what happened after that until 2008, and then again until 2014. (4 marks)
4d.
From Assignment 1, we found another puzzle – the U.S. vs. Canada equity premium puzzle. Using the
calculations from Assignment 1, and assuming monthly t-bill rates of zero (0), explain this puzzle. (4 marks)
4e.
There are several reasons for the puzzle in 4d. Let us examine one reason. It has been suggested that
Canada is an oil-based economy. Using the calculations from Assignment 1, is the TSX index positively related
to the price of oil? How does this explain the puzzle in 4d.? (4 marks)
4f.
There is perhaps another explanation for the puzzle in 4d. Suppose earnings before tax per share or
EBT/share is $1 and the dividend payout rate is 100%. The return on equity or RE is 10%. Suppose the
corporate tax rate is 35% and there is no growth due to zero retained earnings (i.e., zero growth in dividends).
The number of shares also remains constant. First, find the fundamental value of each share P0. (1 mark) Now
suppose the corporate tax rate is cut to 21%. Find the fundamental value of each share P’0 now. What is the
percentage change in the share price? (1 mark) Show that we get the same percentage change in the share price
regardless of what EBT/share or RE is. Hint: Let EBT/share = X and RE = r. (2 marks) What is causing the
share price to increase? Are earnings growing? If not, why is the share price increasing? (2 mark)
4g.
The tax cut and jobs act of 2017 (TCJA) which cut the U.S. corporate tax rate from 35% to 21% was
passed jointly by the U.S. House and Senate on December 20, 2017. Now suppose investors already expected a
corporate tax cut after President Trump was inaugurated in January 2017. From Assignment 1, the Adjusted
Close AC of the S&P 500 index in January 2017 was 2,287.87 while the AC of the S&P/TSX index in January
2017 was 15,386. Also, from Assignment 1, the AC of the S&P 500 index in January 2018 was 2,823.81 while
the AC of the S&P/TSX index in January 2017 was 15,951.7. Assignment 1 also showed the S&P/TSX and
S&P 500 indexes are significantly positively correlated at the 1% level. How could one explain the difference in
returns of the S&P/TSX index and the S&P 500 index in 2017? (4 marks)
5
Question 4 (continued)
6
Question 5 on Risk and Return (CAPM/APT/Canadian Tradition) (20 marks)
5a.
Determine the equation that describes the equilibrium returns for the following portfolios: (9 marks)
---------------------------------------------------------------------------------------------Portfolio
Expected Return (%)
βi1
βi2
---------------------------------------------------------------------------------------------A
33.8
1.6
0.8
B
46.2
2.0
1.2
C
56.5
2.4
1.5
----------------------------------------------------------------------------------------------5b.
Assume there is a portfolio D with βD1 = 1.8. What is the equilibrium return on portfolio D? What is the
sensitivity of portfolio D to factor 2 βD2? What is the relationship of portfolio D to factor 2? (4 marks)
5c.
Suppose there is another portfolio E with the following characteristics: Actual Return = 52.5%; βE1 = 2.0
and βE2 = 1.5. Would you recommend investment in portfolio E? Why? (2 marks)
5d.
It’s Nobel season. List the advantage/disadvantage of the Sharpe’s CAPM vs. Ross’ APT and suggest
why Sharpe’s CAPM received the Nobel prize but Ross’ APT did not. (5 marks)
7