Assignment

Q1. You have been asked by the prospective directors of a shortly to be established business what is meant by ordinary shares, preference shares and debt capital. Further, you have been asked to provide a brief explanation of their relative advantages and disadvantages as sources of funds to expand the business. Write an essay to assist these managers. (300 words max)

Q2. Adam, a speculator, is convinced that the stock market will fall significantly in the forthcoming months. The current market index (14 August) level is 4954 (FTSE 100). He is investigating a strategy to exploit this market fall: sell five FTSE 100 Index futures on NYSE Liffe with a December expiry, current price 5086.

Extracts from the Financial Times

FTSE 100 Index Futures (LIFFE) £10 per full index point

Assume: no transaction costs.

Required: For the derivative

(a) What would the profit (loss) be if the index rose to 5450 in December under the strategy?

(b) What would the profit (loss) be if the index fell to 4550 in December under the strategy?

Q3. A buyer of a futures contract in Imaginationum with an underlying value of £400,000 on 1 August is required to deliver an initial margin of 7.5 per cent to the clearing house. This margin must be maintained as each day the counterparties in the futures are marked to market.

Required:

(a) Display a table showing the variation margin required to be paid by this buyer and the accumulated profit/loss balance on her margin account in the eight days following the purchase of the future.

(Assume that the maintenance margin is the same as the initial margin.)

(b) Explain what is meant by ‘gearing returns' with reference to this example.(Hint: gearing has the same meaning as leverage, note how the returns in the Imaginationum are amplified in the futures contract and comment on it.) (75 words max)

(c) Compare forwards and futures markets and explain the coexistence of these two. (100 words max)

Q4. You hold 20,000 shares in ABC plc which are currently priced at 500p. ABC has developed a revolutionary flying machine. If trials prove successful the share price will rise significantly. If the government bans the use of the machine, following a trial failure, the share price will collapse.Required:

(a) Explain and illustrate how you could use the traded options market to hedge your position.
Further information (Hint: Go for Sept. puts with the 450 exercise price).

Current time: 30 January.

Traded option quotes on ABC plc on 30 January:

(b) What is meant by intrinsic value, time value, in-the-money, at-the-money and out-of-the-money?

Use the above table to illustrate.

Q5.On 14 August British Biotech traded options were quoted on NYSE Liffe as follows:

Assume: No transaction costs.

Required

(a) Imagine you write a December 180 put on 14 August. Draw a graph showing your profit and loss at share prices ranging from 100p to 250p.

(b) Draw a graph showing the buyer's profit and loss at the same share price range.

(c) Compare your answers for (a) and (b) and comment (100 words max).

Q6. Summerville Inc. is considering an investment in one of twocommon stocks. Given the information that follows, which investment is better, based on the risk(as measured by the standard deviation) and return of each?

Q7. (a) Given the holding-period returns shown here, compute the average returns and thestandard deviations for the Zemin Corporation and for the market.

(b) If Zemin's beta is 1.54 and the risk-free rate is 3 percent, what would be an appropriaterequired return for an investor owning Zemin? (Note: Because the returns of Zemin Corporationare based on monthly data, you will need to annualize the returns to make themcompatible with the risk-free rate. For simplicity, you can convert from monthly to yearlyreturns by multiplying the average monthly returns by 12.)

(c) How does Zemin's historical average return compare with the return you believe to be afair return, given the firm's systematic risk?

Q8. You are considering a project with an initialcash outlay of $100,000 and expected free cash flows of $23,000 at the end of each year for 6 years.The required rate of return for this project is 10 percent.

a. What is the project's payback period?

b. What is the project's discounted payback period?

c. What is the project's NPV ?

d. What is the project's PI ?

e. What is the project's IRR ?

f. What is the project's MIRR if the re-investment rate is 10 percent?

g. What is the project's MIRR if the re-investment rate is 12 percent?

Q9. The Cowboy Hat Company of Stillwater, Oklahoma, is considering seven capital investment proposals for which the total funds available are limited to a maximum of$12 million. The projects are independent and have the following costs and profitability indexesassociated with them:

a. Under strict capital rationing, which projects should be selected?
b. What problems are there with capital rationing?

Q10. Destination Hotels currently owns an older hotel on the best beachfrontproperty on Hilton Head Island, and it is considering either remodeling the hotel or tearing itdown and building a new convention hotel, but because they both would occupy the same physicallocation, the company can only do one-that is, these are mutually exclusive projects. Both theseprojects have the same initial outlay of $1,000,000. The first project, since it is a remodel of anexisting hotel, has an expected life of 8 years and will provide free cash flows of $250,000 at theend of each year for all 8 years. In addition, this project can be repeated at the end of 8 years atthe same cost and with the same set of future cash flows. The proposed new convention hotel hasan expected life of 16 years and will produce cash flows of $175,000 per year. The required rateof return on both of these projects is 10 percent. Calculate the NPV using replacement chains tocompare these two projects.

Q11. Rib & Wings-R-Us is considering the purchase of a new smokeroven for cooking barbecue, ribs, and wings. It is looking at two different ovens. The first is a relativelystandard smoker and would cost $50,000, last for 8 years, and produce annual cash flows of$16,000 per year. The alternative is the deluxe, award-winning Smoke-alator, which costs $78,000and, because of its patented humidity control, produces the "moistest, tastiest barbecue in theworld." The Smoke-alator would last for 11 years and produce cash flows of $23,000 per year.

Assuming a 10 percent required rate of return on both projects, compute their equivalent annualannuity (EAA).

Q12. Rocky Mount Metals Company manufactures an assortment of woodburningstoves. The average selling price for the various units is $500. The associated variable costis $350 per unit. Fixed costs for the firm average $180,000 annually.

a. What is the break-even point in units for the company?

b. What is the dollar sales volume the firm must achieve to reach the break-even point?

c. What is the degree of operating leverage for a production and sales level of 5,000 units forthe firm? (Calculate to three decimal places.)

d. What will be the projected effect on earnings before interest and taxes if the firm's saleslevel should increase by 20 percent from the volume noted in part (c)?

Q13. You have developed the following income statement for the Hugo Boss Corporation. It represents the most recent year's operations, which ended yesterday.

Your supervisor in the controller's office has just handed you a memorandum asking for writtenresponses to the following questions:

a. What is the firm's break-even point in sales dollars?

b. If sales should increase by 30 percent, by what percent would earnings before interest and taxes increase?