FINANCE TEST

2021
NAME: PRAJAL GHIMIRAY.

SUB: 1ST FINANCE TEST.

1. The Federal Government is intending on making large cash investment in June and
July of 2021. As a consequence, the government will have a short-term shortfall of $5.5
million between cash receipts and expenditures. The government is intending to meet
this shortfall by issuing 60-day Treasury Notes today. Calculate the face value of this
issue, given a yield of 1.5% pa.

Answer:

Shortfall = 5.5 (in millions)

Time = 60 days
Yield = 1.5%
The formula for calculating face value would be:
Yd = (D/F)* (360/T)
Where: Yd = annualized yield (expressed in decimal)
D = dollar discount
F = Face Value
T = number of days of issuing Treasury Notes
Here, Instead of discount we have shortfall.
1.5/100 = (5.5)/F * (360/60)
1.5/100 = 5.5/F * 6

1.5/100 = 33/F

F = 33/0.015

Face Value = 2,200.

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2. Burning Cash Company raised $1m through a 10-year bond issue on the 31 st of
December 2019. The bond pays 5% pa in coupons, with coupons paid quarterly.
Calculate the price of the bond on the 8 th of June 2021, given a market yield of 4.5%. In
your answer, identify whether the bond is trading at a discount or a premium, and
explain the logic why this is the case.

Answer:

Burning Cash Company issue $1,000,000 of 10-year bond.

The bonds pay interest quarterly (stated 5%)

The market yield interest is 4.5% or 0.045/4 (quarterly) = 0.01125.

Quarterly Interest Paid = 1,000,000 * 5/100

= 50000/4

= 12,500 quarterly.

The formula we used here is,

Price of the Bond = Present Value of Lump sum + Present Value of Interest payments

= Cash flow/ (1+r) n + Cash flow * (1-(1+r)-n)/r

Whereas, cash flow = Present Value

r = Interest rate

n = time

= 1,000,000/ (1 +0.01125)40 + 12,500 * (1 – (1 + 0.001125))-40/0.01125

= 1,000,000/ (1.01125)40 + 12,500 * (1 – (1.001125))-40 / 0.01125

= 1,000,000/ 1.5644 + 12,500 * (1 – 0.9560) / 0.001125

= 6, 39,222.7052 + 12,500 * 0.044/0.001125

= 6, 39,222.7052 + 12,500 * 39.1111

= 6, 39,222.7052 + 4, 88,888.875

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= 11, 28, 111 .58 (bond is trading at a premium because the value of price of the
bond is more than actual price by 1, 28,111.58).

3. The Dividend Granting Company paid a dividend of 45 cents per share today. The
company is expecting their dividends to grow at 4.5% year on year. The company is
planning a 1:5 rights issue at a 10% discount relative to the current market price. The
required rate of return demanded by investors of the Dividend Granting Company is
8%.
a. Calculate the current market price of the Dividend Granting Company based on
the information provided in the question.
b. Calculate the ex-rights share price based on the information provided in the
question.
c. Calculate the price of the right. Explain the advantages and disadvantages of
rights issues.

Answer: a. Current Market Price = Dividend/ (required rate of return – growth rate)

Current Market Price = 0.45 / (0.08 – 0.045)

Current Market Price = 0.45 / 1.778

Current Market Price = 0.253

b. Ex-rights Share Price is to add the current market value of all shares existing
before the rights issue and the funds raised as a result of the rights issue sales.

Therefore, Ex-rights Share Price = 0.253 (current price) * 1/6 * 5/6 * 10%

Ex-rights Share Price = 0.253/ 72

Ex-rights Share Price = 0.352

C. Price of the Right = Current Market Price – Ex-rights Share Price

Price of the Right = 0.253 – 0.352

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Price of the Right = (0.999).

Advantages of Right Issues

Rights issue of shares is a security issued by a company to its existing shareholders. It the fastest
and cheapest method by a company to raise capital, although the value of a share gets diluted.
Generally, companies have a variety of ways to raise equities and rights offering or issues are
one of them. When a company issues rights offering it raises new funds. If you are looking to a
rights issue of shares you need an understanding of rights issues. It gives shareholders an
opportunity to raise their exposure to the stock at a discounted price. Only shareholders on a
given record date will have the right to buy rights shares. Subscribing to a rights issue of share
offer is just like investing in a stock. Let us have a note of the rights issue advantages and
disadvantages.

Rights Issue Advantages

For the company

 Rights offering or rights issue (RI) can produce advantage to the company by allowing
them to raise capital. If a company is struggling financially, this kind of move could assist
them to boost their balance sheet by eliminating debt or injecting new cash flow into the
business.
 This issue can also raise market interest in the company, resulting in new investors buying
and potentially driving the share price up.
 The rights issue over a loan is that company doesn’t have to pay the funds back. A loan
must be repaid, and the financial institute wants interest on top of the repayments. When
the company issue rights share to an investor, it’s a different setup. Instead of the regular
re-payments of a loan, you get an injection of cash you can purely use to build up the
business.
 This issue is a cost-effective event as the companies do not have to pay for advertisements
and underwriters. Offering extra shares at a discount support a company to retain its extant
investor’ confidence.

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For the Shareholder
 The allotment method of rights issue is systematic and depends on the present holding of
existing shareholders.
 The advantages of a rights issue to shareholders are that shares are generally offered at a
discounted price.
 This discount can be quite steep in some condition. However, it all depends on how much
the company feels it needs to encourage its shareholders to purchase the rights issue.
 Whether companies are able to realize a significant gain depends on the market price and
the discounted price. Companies also have to factor in the number of rights you’d be able
to transfer. Normally, the amount of shares an investor can buy via a rights offering is
proportionate to the number of shares they currently own.

Rights Issue Disadvantages

The company may be unable to raise more money and fail to achieve their target. This may
happen if the existing shareholders of the company are not too keen to invest more.

Rights issue can have significant impact on share prices and trading activity in a firm’s security
on the day of the announcement.

1. Value of each share may get diluted after the RI announcement.

2. Raising funds via right issue often creates pressure on the issuer.

3. Investor(s) may lose the holding value if the share price comes down after the RI.

Being a shareholder, we should be able to see beyond the discount offered. A rights Issue is
different from bonus issue, as here we have to pay funds to get additional shares. Therefore, it is
advised that we should subscribe to it only if we are very much sure about the company’s future
performance.

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4. From the figures mentioned below of Umbrella Corp, calculate the Weighted Average
Cost of Capital (WACC).

Interest expenses $443 million

Corporate tax rate 30%

Default spread 1.56%

Market Value of short term debt $885 million

Market Value of long term debt $9,552 million

Market value of operating liabilities $1200 million

Total asset of firm $18,349 million

Systematic risk 0.79

Market value of equity $21,129 million

Risk free rate 1.7%

Market risk premium 4.72%

Answer:

Weighted Average Cost of Capital = (E/V * Re) + (D/V * Rd * (1- Tc)

Whereas, E=Market value of the firm’s equity

D=Market value of the firm’s debt

V=E+D

Re=Cost of equity

Rd=Cost of debt
Tc=Corporate tax rate

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Cost of debt = (1- tax rate)
= (1-0.3)
= 0.7
Cost of equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of
Return)
Calculation of Beta:
Systematic Risk = Risk free rate of return + Beta * (market return – risk free rate of return)
0.79 = 0.017 + Beta * (0.15 – 0.017)
0.79 = 0.017 + Beta * 0.133
0.79 = 0.017 + 0.133 Beta
0.79 – 0.017 = 0.133 Beta
0.773/0.1333 = Beta
5.8 = Beta
NOTE: Market Return value is taken as per 2020 reports)

Cost of equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of
Return)
= 0.017 + 5.8 * (0.15 – 0.017)
= 0.017 + 0.7714
= 0.77884.
Weighted Average Cost of Capital = (E/V * Re) + (D/V * Rd * (1- Tc)

WACC = [21,129/ (21,129 + 10,437) * 0.77884] + (10,437 * 0.7 * (1- 0.3))

= (21,129/31566) * 0.77884 + 5,114.13

= 0.52132 + 5,114.13

= 5,114.65.

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5. Assume annual inflation rates in the US and Australia is 6% and 4% respectively, and
the spot rate is US$0.75 per AUD (indirect quote). What is the value of AUD in 1 and 2
years?

Answer: Annual Inflation Rates = 6% and 4%

Spot Rate = 0.75

Value of AUD = Spot Rate + Actual inflation rate

Difference of two inflation rate = 0.06 – 0.04

= 0.02.

Value of AUD = Spot Rate + Actual inflation rate

= 0.75 + 0.02

= 0.77

6. Suppose that the forward ask price for March 20 on euros is $0.9127 and at the same
time the price of IMM euro futures for delivery on March 20 is $0.9145. How could an
arbitrageur profit from this situation? What will be the arbitrageur's profit per futures
contract (size is €125,000)?

Answer:

Since the futures price exceeds the forward rate, the arbitrageur should sell futures contracts
at $0.9145 and buy euro forward in the same amount at $0.9127. The arbitrageur will earn
125,000 (0.9145-0.9127) = $225 per euro futures contract arbitraged.

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7. (a) Your personal opinion is that security X has an expected rate of return of 0.11. It
has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is
0.09. Based on the Capital Asset Pricing Model, discuss whether this security is under-,
over- or fairly-priced and why.

Answer:

According to the Capital Asset Pricing Model, this security is:

The capital asset pricing model is a model that is used to estimate the returns from security. The
capital asset pricing model can also be used to estimate whether the security is overvalued or
undervalued.

Based on Capital Pricing Model, the expected return is calculated as:

Expected Return = Risk Free Rate + Beta * (Expected Return on Market – Risk Free Rate)

0.11 = 0.05 + 1.5 * (0.09-0.05)

0.11 = 0.05 + 1.5 * 0.04

0.11 = 0.05 + 0.06

0.11 = 0.11

Therefore, the security is fairly priced because there is no difference in expected return and the
return from security.

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b. Based on the return and risk profile of the four portfolios below, discuss which
portfolio cannot lie on the efficient frontier as described by Markowitz?

Portfolio Expected Standard

Return Deviation

A 6% 8%

B 14% 35%

C 12% 14%

D 10% 22%

Answer:

As per Markowitz Rule, The efficient frontier is the set of optimal portfolios that offer the
highest expected return for a defined level of risk or the lowest risk for a given level of expected
return.

As per the above question, Portfolio D cannot lie on the efficient frontier because it has lower
return, but higher risk, than portfolio C.

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8. In a particular year, the spot exchange rate between the Canadian dollar and
U.S. dollar was $0.7554 (per Canadian collar). Interest rates in the U.S. and
Canada were 1.5 percent and 1.25 percent per annum, respectively, with
continuous compounding. The three-month forward exchange rate was
$0.7675, which creates an arbitrage opportunity. Propose one possible strategy
to take advantage of this situation and show your possible profit.

Answer:

Taking Cash Reserve as 100M [0.7554 US dollar = 0.95 Canadian Dollar]

If we invested in US: 100M *0.77554 = US$ 75,540,000

If we invested in Canada: 100M * 0.95 = C$ 95,000,000

75,540,000 * (1+ (1.5%/2)) = 75,540,000 * 1.0075 = US$76, 10,655

76, 10,655/ 0.7675 = US$ 99, 16,162.866

We should exchange $ for Canadian and then invest in US. We should take Canadian +
Canadian interest out and sell them for dollars at the new forward exchange rate of 0.7675$.

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9. A stock price is currently $80. Over each of the next two six-month periods, it is
expected to go up by 6% or down by 6%. The risk-free interest rate is 5% per
year with semi-annual compounding. Use the two-steps binomial tree model to
calculate the value of a one-year American put option with an exercise price of
$80.

Answer:

Stock price = $80

Stock price in one month (up state) = $86

Stock price in one month (down state) = $74

Binomial Value (P) = e(r-q) ⌂t – d/u – d is chosen such that the related binomial
distribution simulates the geometric Brownian motion of the underlying stock with
parameters r and σ, q is the dividend yield of the underlying corresponding to the life of
the option.

In this case U = 1.06, d = 0.74, ⌂t = 0.3 and r = 0.05, so that

P = e0.05 * 0.3 -0.74/1.06 – 0.74

= 0.315 – 0.74 / 0.32

= -1.34

Therefore, the option value can be calculated directly from the equation:

= [(-1.34)2 * 17 + 2 * -1.34 * 02959 * 0 + (0.2959)2 * 0] e-2*0.05*0.3

= [30.5252 +0] e-2*0.05*0.3

= [30.5252] e-2*0.05*0.3

= $6.20

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10. The following information is available:

Spot exchange rate (NZD/AUD) 1.0000

6-month forward exchange rate (NZD/AUD) 1.0070

6-month interest rate in New Zealand 2.0% per annum

6-month interest rate in Australia 1.0% per annum

(i) Does Covered Interest Rate Parity (CIP) hold?

(ii) If CIP does not hold, clearly outline the steps a trader would follow in
order to make arbitrage profits and calculate the profit assuming the
trader has access to NZD 1,000,000 or AUD 1,000,000.

(iii) Assume that the expected inflation rate in New Zealand over the next 6
months is 1.0%, if the Purchasing Power Parity (PPP), Uncovered
Interest Parity (UIP) and Real Interest Parity hold, what will you expect
the inflation rate in Australia to be over the next 6 months?

Answer: Not Attempted due to less knowledge about this concept.

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11. A company just paid a dividend of $5 recently. The company expects the dividend to
grow by 2.5% for next three years, then for 4% for another three years. Finally, the
growth rate of dividend will stay constant at 3% in the future. If the discount rate is 8%
p.a. Find the value of company’s share today.

Answer:

P = {C/R-g1} [1- [(1+g1) T/ (1 + R) T)] + [(Div N+1) / R-g2] / (1+R)

P = [($5 * 1.025) / (0.08 – 0.025)] * [(1- (1.025) 3) / (1.08)3] + [$5(1.025)3* (1.03) / (0.08-
0.03)

P = $ 93.18 * [1-0.855] + [($ 5.546) / (1.1576)]

P = ($93.18 * 0.145) + ($4.791)

P = $ 13.511 + $ 4.791

P = $ 18.30

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