2 Preparing for the 2nd Assessment Exam How to do well on my exams (by order of what I think is most important):1. Review the PowerPoints for each classThese are the things I consider importantEspecially look for application problems and know how to do them2. Review the previous quizzes and examsCheck your answers from the net3. Review the homework problems and readingsThink through the purpose for each problem
3 Problem 1: Economic Analysis What monetary and fiscal policies might be prescribed for an economy in a deep recession?
4 AnswerExpansionary (i.e., looser) monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables.Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.
5 Problem 2: Industry Analysis In which stage of the industry life cycle would you place the following industries. Note that there is often considerable room for disagreement concerning the “correct” answers to this question (use start-up, consolidation, maturity, and decline as your major stages).A. Oil well equipmentB. Computer hardwareC. computer softwareD. Genetic engineeringE. Railroads
6 Answer a. Oil well equipment. Possible decline worldwide, due to environmental pressures and a decline in easily-developed oil fields, but may be in maturity in the US due to increased need for energyb. Computer hardwareGenerally a consolidation or maturity stagec. Computer softwareLikely in a consolidation stage currentlyd. Genetic engineeringLikely in a start-up stagee. RailroadsLikely in Relative decline
7 Problem 3: Equity Valuation A common stock pays an annual dividend per share of $ The risk-free rate is 7% and the risk premium for this stock is 4%. If the annual dividend is expected to remain at $2.10, what is the value of the stock?
8 AnswerIf the risk premium on the stock is 4%, and the risk-free rate is 7%, then the require rate on the stock would be 11%. Given a forecast dividend of $2.10, divide that by your 11% discount rate to give a price of = $19.09
9 Problem 4: Financial Statement Analysis An analyst applies the DuPont system of financial analysis to the following data for a company:Leverage ratio 2.2Total Asset turnover 2.0Net Profit Margin 5.5%Dividend payout ratio 31.8%What is the company’s return on equity?
10 Answer The goal is to get earnings over equity. Leverage is Assets/EquityAsset turnover is Sales/AssetsProfit Margin is Earnings/SalesPayout ratio is Dividends/EarningsIf we take:Earnings/S * S/A * A/Equity, the Sales and Assets cancel to give Earnings over Equity. Numerically, it is:5.5% 2.0 2.2 = 24.2%
11 Problem 5: TaxesYou are choosing a fund that you will put in your investment (non-retirement) account. Assuming distribution and operating activities which occurred in the past will likely continue, which of the following funds should you include in your taxable (non-retirement) account. Assume federal taxes on short term distributions are 35% and state taxes are 7%. How would this change if these were both stock funds?Mutual Funds Fund A Fund BBeginning NAV $ $10.00YTD Nominal returns 10% %Estimated Turnover 10% %Short-term distributionsEnding NAV
12 Answer Mutual Funds Fund A Fund B Beginning NAV $10.00 $10.00 Short-term distributionsEnding NAVTax on ST distributions 35%+7% %+7%Taxes paid (w/o selling)After-tax return % %Loss from return due to taxes % %Although both have the same before-tax return, fund B had a 35% lower return due to taxes. Fund A is the better choice for a taxable account, while either fund could be used for a retirement account
13 Problem 6: Stock Performance Last year you purchased 100 shares of MAM Corporation for $40 per share. Over the past 12 months MAM’s share price has gone up to $45 per share, and you received a dividend of $1 per share. What was your total rate of return on your investment in MAM stock?
14 Answer You can do this problem two ways. First, total payout. (($4,500-$4,000) + 100) / $4,000 = ?15%Or, share amount($45 – 40) + 1 / 40 = ?
15 Problem 7: Stock Performance Your investment in MAM stock was so successful that you decided to hold it for 5 more years. Remember, you purchased 100 shares for $40 per share. Unfortunately, the price of MAM stock has not risen; it is back to where you purchased it. The good news is that you earned $1 per share for five years. Calculate your annualized total rate of return. Compared to a bank account earning 2% APY, how did your stock do?
16 Answer The easy way: $1/$40 = 2.50% Or [1+(($4,000-$4,000) + 500) / $4,000)](1/5) = 2.38%The stock performed better than the bank account
17 Problem 8: Retirement Planning Andrew and Suzy recently reviewed their future retirement income and expense projection. They hope to retire in 30 years. They determined that they would need an annual retirement income of $80,000 in today’s dollars, but they currently only have $25,000 annually with expected Social Security and savings.Calculate the total amount that Andrew and Suzy must save for retirement if they wish to meet their income projection, assuming a 3% inflation rate before retirement and 2% after, and an 8% return before retirement and 6% after retirement. They believe they will be in retirement for 25 years.
18 Answer First, draw the diagram 1. Calculate the Shortfall 2. Inflation adjust the shortfall3. Calculate the real return and the annuity4. Calculate the period paymentTime years yearsReturn % Return %Inflation % Inflation %Now Retirement Death
19 Answer 1. The annual shortfall is: 80,000 – 25,000 = ? The shortfall is $55,000.2. To get the inflation adjusted amount, we use: PV = -55,000, I/Y = 3, N = 30, and solve for FV which gives the amount that they need annually in retirement.FV of $133,499
20 Answer3. To get the real return and the annuity for 25 years, calculate the real return with 6% nominal and 2% inflation, which gives a real return of ?Real return of 3.92% = [(1.06)/(1.02)] – 1.The annuity required is PMT = $133,499, I = 3.92, N = 25, PV = ?The annuity needed is $2,103,2794. to get the amount to save, it is I = 8%, N = 30, FV = $2,103,279, and PMT = ? To give what you need to save each yearThey need to save $18,567 to reach their goalst your individual level of savings or your current financial condition.
21 Problem 9: International Investing If the current exchange rate is $1.75/£, the one-year forward exchange rate is $1.85/£, and the interest rate on British government bills is 8% per year, what risk-free dollar-denominated return can be lock in by investing in the British bills?
22 AnswerThe formula is: (1 + r(US)) = (1 + r(UK)) (F0/E0). (F0/E0) is just 1 + the return from the currency. To get the US return, solve for:= 1.08 * (1.85/1.75) = = 14.17%F0 is the forward rate. E0 is the exchange rate