QUESTION 1

(a) Explain how CAPM provides a framework for measuring the systematic risk of an individual security in a well-diversified portfolio, using the concept of security market line.

(b) Mr. Douglas has asked for your advice in selecting a portfolio of assets. The following data has been supplied:

No probabilities have been supplied. You have been told that you can create two portfolios:

• One consisting of assets A and B
• One consisting of assets A and C

Both by investing equal proportions (50%) in each of the two component assets.

Required:

• What is the expected return for each asset over the 3 year period?
• What is the variance for each asset's return?
• What is the expected return for each of the two portfolios?
• What is the variance for each portfolio?
• Which portfolio do you recommend? Why?

(c) Mr. James is the owner of a small enterprise; he has decided to buy a machine. He can afford to pay Rs. 10, 000 per month. He visited the bank and found that the going rate is 1.5% per month for 48 months. How much can he borrow?

(d) A company has issued debentures of Rs 500, 000 to be repaid after 7 years. How much should the company invest at the end of each year in a sinking fund earning 12% in order to be able to repay debentures?

QUESTION 2

Prestige Perfect Cooker Company is a manufacturer of aluminium utensils. Two new automated process machines used in the production of aluminium utensils have been introduced to the market, the MLH and the NSA. Both will give cost savings over existing processes:

All other factors remain constant and the firm has access to large amounts of capital. The required return on projects is 4%.

Required:

a) Calculate the IRR for MLH using trial rate of 21% and 22%.

b) Calculate the IRR for NSA using trial rates of 18% and 25%.

c) Based on IRR which machine would you purchase?

d) Calculate the NPV for each machine.

e) Based on NPV which machine would you buy?

f) In assessing capital investments, finance managers generally use three techniques - payback period or discounted payback period, IRR and NPV. Of the three, which one is most suitable for evaluation of capital investments? What kind of problems would you foresee in other techniques and under what conditions would you use them?

QUESTION 3

Part A:

You are considering three alternatives investments in bonds but would like to gain an impression of the extent of price volatility for each given alternative changes in future interest rates. The investments are:

I. A two year bond with an annual coupon of 6 per cent, par value of Rs 100 and the next coupon payment in one year. The current yield to maturity on this bond is 6.5 per cent.

II. A ten year bond with an annual coupon of 6 percent a par value of Rs 100 and the next coupon payable in one year. The current yield to maturity on this bond is 7.2 per cent.

III. A 20 year bond with an annual coupon of 6 per cent, a par value of Rs 100 and the next coupon due in one year. The current yield to maturity on this bond is 7.7 per cent.

Required:

a. Draw an appropriate yield curve.

b. Calculate the market price of each of the bonds.

c. Calculate the market price of the bonds on the assumption that yields to maturity rises by 200 basis points for all bonds.

d. Calculate the market price of the bonds on the assumption that yields to maturity fall by 200 basis points for all bonds.

e. Which bond price is the most volatile in circumstances of changing yields to maturity? Provide supporting reasons.

Part B:

You own shares of Dickson's preferred stock, which currently sells for Rs. 400 per share and pays an annual dividend of Rs. 42.50 per share.

(i) Calculate expected return.

(ii) If you require an 8% return, given the price, should you sell or buy more stock?

(iii) The earnings of the Company have increased over a 10 - year period to Rs 57. Compute the rate of growth of the earnings per share.

(iv) Why is preferred stock more similar to debt than equity?

QUESTION 4

(a) Discuss fully the difference between systematic risk and unsystematic risk and highlight the importance of such a distinction for investors.

(b) Briefly describe and differentiate the weak, semi-strong and strong form of Efficient Market Hypothesis.