1. Please explain the intuition (without using any mathematics) why zero-coupon
bonds generally are more sensitive to interest rate change than coupon bonds.
Assume there is no default risk and the yield curves are flat now and in the future.
2. Global Champion is a company with only one product under development. The
product is a drug with potential to cure one type of cancer. If successful, people
are expected to be willing to pay for the drug because of its superior effectiveness. The only risk the company faces is whether the drug is effective or not. Based on
CAPM, what should the rate of return of the stock? Please explain.
3. Project Ching has MIRR of 20% while Project Yan has MIRR of 22%. Is it possible that Project Ching actually increase the value of the firm more than Project Yan? Please
4. Alex advised his client, Yat, to buy 400 shares of UBKH stock when the price was $100 per share last week. Today the stock price drops to $90 per share. Alex suggests that Yat buy additional 400 shares to lower the average cost from $100 per share to $95 per share. He argues that Yat can break even when the stock price goes up by $5 from today’s price, instead of $10. He will recover his money easier. Please comment on what is missing in Alex’s argument.
5. CPL provides electricity to Kowloon. Many old people buy its stock to get its high
dividend, currently at 4%, for their retirement. Alex tries to sell a one-year bond
whose coupon rate is linked to the stock price of CPL. One year later, if the stock
price of CPL is below today’s level, the coupon rate of this special bond is zero.
Investors of these bonds will have their principal back. However, if the stock price
of CPL goes up by x%, investors will get coupon rate of x%. Now Alex approaches
Vivian. He says, “Investing in this special bond is better than investing in the
stock of CPL since you will not lose money with this bond. Investing in this
special bond is also better than investing in a regular bond since you will get
more money with this bond if the stock price of CPL goes up.” Ignore default
risk and liquidity risk. Please comment on Alex’s two statements.
6. In order to reduce risk, insurance companies buy insurance from reinsurance
companies. When a particular pre-defined catastrophe happens, the reinsurance
companies pay money to insurance companies to reduce their loss. However, the
costs of these reinsurances are very high. Insurance companies find that it is much
cheaper to reduce their risk by issuing catastrophe bonds (also known as cat
bonds) to institutional investors (including hedge fund managers). According to
INVESTOPEDIA, a cat bond is “a high-yield debt instrument that is usually
insurance-linked and meant to raise money in case of a catastrophe such as a
hurricane or earthquake. It has a special condition that states that if the issuer
(insurance or Reinsurance Company) suffers a loss from a particular pre-defined
catastrophe, the issuer's obligation to pay interest and/or repay the principal is
either deferred or completely forgiven.” From what we learn in this course, please
explain why the cost of cat bonds is much lower than the cost of reinsurance.
Assume that investors and issuers have the same information on the catastrophe
(probability and magnitude of loss) and they are rational.
7. Alex claims that the incremental IRR will solve all the problems of the IRR. Kwan Wai is a quiet lady. But she has excellent critical thinking. She politely suggests to Alex that he might accidentally forget one thing. What is mostly likely Alex’s mistake?
8. Ivy observed the following information on two mutual funds, Raymond Fund and Na Fund. Based on the observed information, which fund most likely has more stocks? Please explain.
Standard deviation Beta Fund size
Raymond Fund 50% 1.05 $2.4 billion
Na Fund 20% 1.10 $ 2.5 billion
9. Tina, a world-known businesswoman, makes the following forecasts. The U.S.
economy will get worse. The 10-year interest rate will drop. Suppose the market
does not see what Tina sees now but it will realize that Tina is correct three
months later. Will U.S. government bonds or asset-backed securities with credit-
card accounts receivable as underlying asset with similar maturities have higher
rate of return? Please explain.
10. China Steel is a steel company. It borrowed heavily to buy fixed assets. As a result, the company has negative earnings. The company is very cyclical (very sensitive to change in economy). Hence, future performance is difficult to predict. Alex suggests that the
following methods be used in the valuation of China Steel stock: P/E ratio, P/B ratio, PEG, EV/EBIDA and discount cash flow model. Please help Nick to pick the two most appropriate methods and explain.
11. Pension funds do not pay tax. Normally they do not invest in tax-free (non-taxable) bonds. However, when Clinton, a democrat, beat his opponent, a Republican and won the presidential election of the United Sates, some pension funds bought tax-free bonds. Investors generally believe that Democrats will ask rich people to pay more to the government to help to pay for the expansion of social programs. Please explain why pension fund managers bought tax-free bonds even though pension funds do not pay taxes.
12. Vivian and Angela, the financial analysts of a Company, work under Johnny. They use the cost of capital given to them by Johnny to calculate the NPV to select projects to invest. Vivian has one project of which most of the cash flows appear early in the life of the project, while Angela has a project of which most of the cash flows appear late in the life of the project. Other parameters (like lives) are
identical. It happens that both projects have the same NPV. Now, Johnny tells
them to use a higher cost of capital. Whose project will be better under the new
cost of capital? Please explain.
13. Ann went to an interview with Goodman Company. She was asked whether the WACC for high-tech companies is higher or lower than the WACC of utility companies. Please help Ann to explain.
14. Alex, an employee of Big Word Bank, is trying to sell an investment product called “accumulator” related to the stock price of Amazon to Rax. Rax needs to put in $10 million in Big Word Bank. If the stock price of Amazon goes up by 10% (from the current price of $200 to $220) in the coming year, Rax will get 10% rate of return on his money right away. He does not have to wait for one year to get the 10% interest. If the stock price of Amazon drops to $140 any time in the coming year, he will have to buy 50,000 shares of Amazon at $180 per share. If neither of the above conditions happens in the coming year, Rax will get back his money with 10% rate of return. Alex claims that this accumulator is a better investment than the stocks of Amazon and the one-year fixed-rate C.D. in Big Word Bank. Alex has two arguments. The first argument is that the accumulator can earn 10% rate of return (possibly with a much higher annualized rate of return), higher than the 2% offered by 1-year C.D. The second argument is that Rax can buy stocks of Amazon at $180 per share, lower than the current price of $200 per share. This accumulator is a win-win investment. Please comment on Alex’s two arguments. Assume liquidity risk and default risk can be ignored.
15. Alex thinks that junk bonds (also known as high-yield bonds) are very risky in comparison to government bonds. However, he observes that the variance of the returns of mutual funds investing in junk bonds of various companies is about the same as the variance of mutual funds investing in U.S. government bonds. He asks Kenny. Kenny is a very smart student of Alexander the Great. How can Kenny explain this to Alex? Assume variance is a good measure of risk. The sampling period includes various business cycles. The average maturities of these mutual funds are about the same.
16. Investment professionals always say “Good companies are not good stocks”. Please explain the rationale behind this statement.
17. Alex claims that the use of profitability index is always consistent with the goal of financial management. Please comment on Alex’s claim.
18. Jacklin, an expert in finance, claims that the beta of a stock is close to zero. Tamie finds that the daily returns of the stock vary a lot. Alex claims that one of them must be wrong and he asks Sally for her opinion. Please help Sally to explain to Alex.
19. During the financial tsunami, holders of corporate bonds who wanted to sell their bonds could not find any buyer since investors were so scared of risk. The liquidity was just dried up. Michael was the treasurer of Handsome Men Limited. The company wanted to raise capital by issuing bonds but could not find any buyers. What type of bond might reduce investors’ worry about liquidity? Please explain.
20. The cost of capital is 10%. Please calculate the NPV and MIRR of the project with the following cash flows.
Years 0 1 2 3 4
Cash flows -400 200 600 200 50
21. Warren Buffett suggested that investors put money into the index fund (a proxy for themarket portfolio) and T-bills. The index fund has an expected return of 12% and
standard deviation of 24%. The interest rate of the T-bill is 4%. Elaine decides to
follow Buffett’s recommendation and is willing to accept a standard deviation of
18%. What is the expected rate of return of Elaine’s portfolio?
Submitted: 12 months ago.
Category: Multiple Problems