AB1201

Proposed answers for AB1201 Exam sem2AY2020-21

Section A

Question 1 @ 3.5 marks each (TOTAL 14 marks)

1a)
Holding only one stock, an investor faces with total risk which is measured by standard
deviation of the stock’s return. For a diversified portfolio, the relevant risk is the portfolio’s
market risk which is measured by beta. The portfolio’s beta is a weighted average of its
individual securities’ betas. Rational investors would choose to hold a portfolio because
diversification can eliminate some diversifiable risk.

1b)
The five factors are:
• Real risk-free rate of return
• Inflation premium
• Default risk premium
• Liquidity premium
• Maturity risk premium

1c)
When a company issues bonds with sinking fund, it commits contractually to set aside cash
amount to reduce the outstanding bonds annually, this may cause larger annual cash drain on
the company (compared to regular bonds that pays only annual interest to bond holders). The
company would therefore have lower amount of cash for use in its business operation.

1d)
1. Stand-alone risk: measured by the variability of the project’s expected returns;
diversification is totally ignored.

2. Corporate/Within-firm risk: Some of the risk will be eliminated by diversification of

projects within the firm (does not assume the project to be the only one the firm has);
measured by the project’s impact on uncertainty about the firm’s future returns.

3. Market risk: riskiness of the project as seen by a well-diversified investor; measured by its
effect on the firm’s beta coefficient.

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Section B

Question 2 @8 marks each (TOTAL 32 marks)

2a)

i) By computing EAR of each bank, Banks A, B, and C offer 2.529%, 2.718% and
2.574%, respectively. Thus, she should deposit her money in Bank B because of its
highest EAR.

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ii) FV at the end of 5 years of $500 annuity due is higher than that of an ordinary annuity
(because each deposit earns one more period of interest) therefore, she should deposit
at the beginning of each month (an annuity due).

iii) By comparing the EAR of each bank, bank D charges 3.042% while bank E charges
3.239%. Bank D charges lower EAR thus, she should borrow from Bank D.

iv) If she takes 25-year loan, the total payment each year/period will be smaller amount
compared to a 20-year loan. However, the total amount of interest payment for 25-year
loan will be larger.
The annual payments would remain the same amount. However, the dollar amount of
interest paid each year would decrease while the dollar amount of principal paid each
year would increase as the loan approaches maturity.

2b)
Step 1: Forecast the earnings per share of the company.
Step 2: Find the P/E of a comparable listed company as the benchmark P/E.
Step 3: Multiply the forecasted EPS into the benchmark P/E to find the offer price for the share.

Some limitations of using P/E ratio to value the offer price:

1. Not able to find a comparable company whose stocks is already listed.
2. The stock’s price of the comparable company may be overvalued, causing it to have a
high P/E. This would make the estimation inaccurate. This method assumes that the
comparable firm is priced correctly.
3. P/E may not be stable over time.
4. When EPS is negative, this method is not appropriate for estimating the IPO offer price
since the offer price will be negative.
5. Forecasted EPS may not be accurate.

2c)
There are many reasons why many companies do not operate at their theoretical optimal capital
structures. Some of the reasons are:

(1) Certain industry such as those in the real estate tend to have higher debt (than what their
optimal capital structures suggest) due to the fact that their assets are easily used as security for
loans.

(2) Small companies usually have limited access to bank loans, so their low debt level may be
dictated by their inability to borrow rather than by what their optimal capital structures suggest.

(3) Unlisted companies are unable to raise debt or equity financing in the public market
compared to listed companies. It is also difficult to estimate the intrinsic or market values of
unlisted shares. It is therefore more difficult for unlisted companies to estimate their optimal
capital structures.

2d)
1. Reinvestment assumption: IRR assumes the cashflow are reinvested at IRR; NPV assumes
the cashflow are reinvested at WACC rate. NPV’s assumption is more realistic than IRR’s.
2. IRR ignores the magnitude of the investment (e.g., when two projects have different scale).
When mutually exclusive projects are compared against each other, IRR can lead to wrong
conclusion.
3. If the cash flows are non-normal, there is a possibility of multiple IRR.

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MIRR:
Changes the reinvestment rate assumption from IRR to WACC.

There will not be multiple solutions (i.e., ONE single solution) for MIRR.

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Section C

Question 3 (TOTAL 15 marks)

(a)

First consider only the first year (i.e., t=0 to t=4), find FV4:

0 r 1 2 3 4
|--------|--------|--------|--------|
6k 8k 10k 0
FV4 = ?

Quarterly periodic rate = (1 + 3%/12)3 – 1 = 0.7519%

Considering only the first year (i.e., t=0 to t=4), find FV4:

FV4 = 6,000(1+0.7519%)3 + 8,000(1+0.7519%)2 + 10,000(1+0.7519%)

= $24,332.2981

Consider the value of FV4 repeating itself for 20 years:

0 i 1 2 3 4 20
|--------------|-----------------|-----------------|-----------------|------ - - - ------|
24,332.2981 24,332.2981 24,332.2981 24,332.2981 24,322.2981
FV20 = ?
i = (1 + 3%/12) – 1 = 3.0416%
12

FV20 = 24,332.2981(1+3.0416%)19 + 24,332.2981(1+3.0416%)18 + …+ 24,332.2981

= $656,591.38

(b)

0 i 1 2 3 49 50
|--------------|--------------|--------------|----- - - - ----------|---------------|
P P P P P
PV = 750,000

i = (1 + 3%/12)6 – 1 = 1.5094%

750,000 = P + P/(1+1.5094%) + P/(1+1.5094%)2 + P/(1+1.5094%)3 + … + P/(1+1.5094)49

➔ P = $21,154.03 for every six-month or annual P = $42,308.06.

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Question 4 (TOTAL 12 marks)

4a)

Bond X:

YTM = 6.1345% thus, YTM/4 of Bond X = 1.533625%

𝑃𝑀𝑇 1 1,000
990 = 0.01533625
(1 − 10×4 ) + 40
(1+0.01533625) (1+0.01533625)

PMT or coupon payment for Bond X = $15 per quarter or annual coupon of $15×4= 60.

Bond Y:

YTM/2 for Bond Y = 0.050418/2 = 0.025209.

60/2 1 1,000
1,100 = (1 − ) +
0.025209 (1 + 0.0025209)𝑁×2 (1 + 0.025209)2𝑁

2N = 30 Thus, Bond Y has 30/2 = 15 years left to maturity.

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4b)

rs = 5 + (10 – 5)1.25 = 11.25%

D1 = 1.3(1.15) = $1.495, D2 = 1.495(1.15) = $1.71925

D3 = 1.71925(1.05) = $1.805213

1.805213
P2 = D3/rs-g = = $28.8834
0.1125−0.05

Expected dividend yield during the third year:

𝐷3 1.805213
= = = 0.0625 𝑜𝑟 𝟔. 𝟐𝟓%
𝑃2 28.8834

Alternatively, since from year 2 onwards, g is constant forever, therefore the growth rate g is
the same as the stock’s capital gains yield.
Thus, the dividend yield = rs – g = 11.25% - 0.5% = 6.25%.
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Question 5 (TOTAL 15 marks)

Cost of debt capital:

95/2 1 1,000
891 = (1 − )+
𝑌𝑇𝑀/2 (1 + 𝑌𝑇𝑀/2)15×2 (1 + 𝑌𝑇𝑀/2)15×2

YTM = 5.5%×2 = 11% (this is the current cost of debt capital).

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To find new (forecasted) cost of debt capital when price = $800,
95/2 1 1,000
800 = (1 − 15×2
)+
𝑌𝑇𝑀/2 (1 + 𝑌𝑇𝑀/2) (1 + 𝑌𝑇𝑀/2)15×2

New YTM = 6.24%×2 = 12.48% (this is the new cost of debt capital)

Difference in cost of debt capital = 12.48% - 11% = 1.48% (increased)

Cost of equity capital:
First, using CAPM, find current stock beta. 11.50% = 5 + beta (6); beta = 1.083.
Then use Hamada equation and current debt/equity of 25/75 to find beta of unlevered firm.
25
1.083 = 𝑏𝑢 [1 + (1 − 0.4) ( )]
75
bu= 0.9028.
Now, use Hamada equation again and new D/E of 60/40 to find new beta.
60
𝑏𝐿 = 0.9028 [1 + (1 − 0.4) ( )] = 1.7153
40
Finally, use CAPM to find new cost of equity.
rS= 5 + 6(1.7153) = 15.29%
Difference in cost of equity capital = 15.29% - 11.5% = 3.79% (increased)

Weighted average cost of capital:

Current WACC = 0.25×11% (1-0.40) + 0.75(11.50%) = 10.28%
New WACC = 0.60×12.48% (1-0.40) + 0.40(15.29%) = 10.61%
Difference in WACC = 10.61% - 10.28% = 0.33% (WACC is increased slightly).
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Question 6 (TOTAL 12 marks)

a)
𝐷1
𝑃0 = ,
𝑟𝑠 −𝑔
𝑁𝐼 𝐸𝑃𝑆×𝑁𝑜 𝑠ℎ𝑎𝑟𝑒𝑠 𝐸𝑃𝑆
ROE = = =
𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃0 ×𝑁𝑜 𝑠ℎ𝑎𝑟𝑒𝑠 𝑃0
$5
𝑃0 = 50, 𝐷1 = $5 ∗ 30% = $1.5, 𝑔 = 𝑅𝑂𝐸 ∗ (1 − 30%) = $50 ∗ 70% = 7%
𝐷1 1.5
Hence, 𝑟𝑠 = +𝑔 = + 𝟕% = 𝟏𝟎%
𝑃0 50
b)
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𝐷1
𝑃0 = ,
𝑟𝑠 −𝑔
𝐷1 = $5 ∗ 40% = $2,
$5
𝑔 = 𝑅𝑂𝐸 ∗ (1 − 40%) = ∗ 0.6
𝑃0

Hence
2
𝑃0 = 5
9%−( ×0.6)
𝑃0

Solving this equation: 0.09𝑃0 − 3 = 2, 𝑃0 = $55.56

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