Bond Spreads and Government Policy
Added on 2020-02-19
11 Pages2054 Words51 Views
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Business Finance
Question 1Expected return on each security using CAPM is as follows:E(r) = Rf + ß (Rm - Rf )Share A E (r) = 3% + 1.5 (8% - 3%)= 10.5%Share B E (r) = 3% + 0.6 (8% - 3%)= 6%Share C E (r) = 3% + 1.2 (8% - 3%)= 9%Share D E (r) = 3% + 1.8 (8% - 3%)= 12%a)SecurityExpected return using CAPMExpected return of investorShare pricingA10.5%14%OvervaluedB6%8%OvervaluedC9%9%Correctly pricedD12%10%Undervaluedb)Beta measures the volatility of a stock in comparison to the stock market. A beta of 1 means the stock has same volatility as the market, a beta more than 1 means the stock has higher volatility than the market and a beta of less than 1 means the stock has a lower volatility than the market. Stock portfolios build with low volatility stocks tend to outperform the high beta growth stocks. This is because these stocks have low volatility resulting in gradually increasing dividend income and due to low volatility the price also remains more or less stable [ CITATION Fin11 \l 16393 ]
In the present case also, share A and B have low beta as compared to share D. Even though share D is undervalued and both shares A and B are overvalued, however a portfolio of low beta stocks will tend to outperform share D as they have low volatility.c)The NPV of the three projects is presented below:YearCash FlowsPVPresent value of cash flowsProject AProject BProject CProject AProject BProject C -20,000 -40,000 -70,000 1 -20,000 -40,000 -70,0001 18,0005,000 30,000 0.893 16,071.4 4,464.3 26,785.72 18,000 10,000 30,000 0.797 14,349.5 7,971.9 23,915.83 18,000 30,000 40,000 0.712 12,812.0 21,353.4 28,471.24 80,000 50,000 0.636 - 50,841.4 31,775.95 1,00,000 1,80,000 0.567 - 56,742.7 1,02,136.8 NPV 23,233.0 1,01,373.8 1,43,085.5 According to the NPV the ranking of the projects is:RankNPVProject11,43,085.5C21,01,373.8B323,233.0Ad)The payback period for the company is as follows:YearCash FlowsCumulative cash flowsProject AProject BProject CProject AProject BProject C- -20,000 -40,000 -70,000 -20,000 -40,000 -70,000 1 18,000 5,000 30,000 -2,000 -35,000 -40,000 2 18,000 10,000 30,000 16,000 -25,000 -10,000 3 18,000 30,000 40,000 34,000 5,000 30,000 4 80,000 50,000 85,000 80,000 5 1,00,000 1,80,000 1,85,000 2,60,000 Payback Period1.11
years2.83 years2.25 yearsSince the company has a policy of accepting projects with a payback period of less than 2.75 years, hence the company would accept projects A and C. project B has a payback period of 2.8 years which is higher than the acceptable.e)Profitability indexProject AProject BProject CPV of future cash flows 43,233.0 1,41,373.8 2,13,085.5 Initial investment 20,000 40,000 70,000 PI2.23.53.0Internal rate of returnProject AProject BProject CIRR72%56%56%Question 2Price of house = $700,000Down payment = 10% of $700,000 = $70,000Home loan to be taken (P) = $700,000 - $70,000 = $63,000Interest rate (r) = 3.5%a)Annual repayments for Sam for a 20 years loan period and 25 year loan periodLoan instalment = r (P) / (1-(1+r)-n)Loan instalment for 20 years loan period = (0.035*630000) / (1-(1+0.035)-20)= $22050 / 0.497= $44,327.5Loan instalment for 25 years loan period = (0.035*630000) / (1-(1+0.035)-25)= $22050 / 0.576
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