Finance Problem Set

This assignment presents a series of problems related to financial valuation and risk management. The first problem involves calculating the intrinsic value of a corporation's stock using a dividend discount model, considering varying dividend growth rates and the impact of credit rating changes on the cost of equity. The second problem focuses on calculating free cash flow to equity (FCFE) per share and using it to determine the intrinsic price of a company's shares, comparing it to the dividend discount model. The third problem explores the advantages and disadvantages of an incentive plan based on return on equity (ROE). The fourth problem involves analyzing options pricing using market data, calculating the cost of options, time value, and profit/loss scenarios. The fifth problem delves into the Black-Scholes model for option valuation and put-call parity. Finally, the assignment concludes with a hedging problem using S&P 500 index futures, requiring the calculation of cash flow and an explanation of basis risk.

3. TTY Corporation has just paid a dividend of $2.30 per share. This dividend is expected to
grow by 15% next year, 10% the year after that, and then dividend growth will level off and
grow in perpetuity at 5%. You believe that the company’s cost of equity capital is 16.5%.
The company’s bonds are rated as “AA” by Standard & Poor’s.
What is your estimate of the intrinsic value of TTY Corporation?
 If the company’s bond rating were to fall to “C”, would you expect the cost of equity
to fall or rise? Why? What would this do to the price of the stock?
 What is the percentage change in the value of TTY stock if the final growth rate of
dividends, currently at 5%, rises to 6%, or falls to 4%?

4) Xterra, Inc. has the following:
Operating Earnings $1,240,000 Shares outstanding 1,000
Depreciation $44,000 Changes in Working Capital 25,000
Other Operating Costs $34,000 Cost of equity 14%
Tax Rate 24%
Bonds outstanding $500,000
Coupon rate on bonds 5%
Capital expenditures $100,000
1. Calculate Xterra’s Free cash flow to equity (FCFE) per share.
2. If FCFE is expected to grow at 4% per year indefinitely, calculate the intrinsic price of the
company’s shares
3. Give three situations in which would want to use the FCFE approach instead of the Dividend
Discount Model (DDM) to value a stock.

5) The board of Directors of a company is considering an incentive plan for its new president.
They are considering paying a cash bonus equal to the president’s salary times (1+ROE) each
year for the next five years. Using the Dupont decomposition of ROE, give two advantages and
two disadvantages of this plan.

6) Options on Company X are available in the market as
Current X Stock Price $95.00
Calls Puts
Expiration date Strike Last Last
February $100.00 $1.00 $4.90
March $100.00 $2.80 $6.47
April $100.00 $4.10 $7.83
a. What would it cost you to buy the right to sell 100 shares of Stock X prior to the expiration
date in April?
b. What is the time value of the
March 100 call?
c. If you bought the March 100 Call contract, and the actual value of
Stock X was $105 at the expiration date, what was your profit?

7) An option has the following characteristics:
Exercise Price $50
Volatility .23
Time to expiration .25 years
Risk free rate 4.6%
Current stock Price $64.76
1. Use the Black Scholes model to value the call.
2. Use put call parity to value the put.
3. Explain how changes in the exercise price, the time to expiration, the stock price and the
volatility affect the price of the calls.

8) You own a portfolio of $5.0 million dollars of stock. The portfolio is weighted towards
technology shares, and contains no financial stocks.
 You want to hedge this portfolio with the S&P 500 Index Futures. the futures have
an initial margin rate of 5% of the contract value, and a multiplier of 250. If the value
of the S&P 500 index is 2,350, what is your total cash flow on the day you do this
hedge trade?
 Describe the hedge – would you buy or sell the futures contract?
 Explain what is meant by “basis” risk in this trade.
 If the S&P 500 index rose by 5%, what would be the profit or loss on your futures
trade?