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Session 25 Practice Problems

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35 views2 pages

Session 25 Practice Problems

Uploaded by

muskaan.k1
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Session 25 Practice Problems FAC633

Ahmedabad University
AY 2023-24| Monsoon Semester
FAC633: Security Analysis and Portfolio Management

1. A company forecasts free cash flow in one year to be -$10 million and free cash flow in two years
to be $20 million. After the second year, free cash flow will grow at a constant rate of 4 percent
per year forever. If the overall cost of capital is 14 percent, what is the current value of the firm?

2. A stock analyst has obtained the following information about J-Mart, a large retail chain:
The company has non-callable bonds with 20 years maturity remaining and a maturity value of
$1,000. The bonds have a 12 percent annual coupon and currently sell at a price of $1,273.8564.

Over the past four years, the returns on the market and on J-Mart were as follows:

Year Market J-Mart


1999 12% 15%
2000 17% 22%
2001 -4% -8%
2002 20% 24%

The current risk-free rate is 6.35 percent, and its tax rate is 35 percent. The company anticipates that
its proposed investment projects will be financed on the same lines as its existing capital structure of
70 percent debt and 30 percent equity. What is the company’s estimated weighted average cost of
capital (WACC)?

Assume that the company has reached steady-state condition and its target capital structure is the
same as prevailing (current) capital structure and that the company has a policy of maintaining
constant debt-equity ratio as indicated above. If so, derive the unlevered cost of equity of the firm.

3. A new plant entails an investment of Rs. 5,000 million in fixed assets. The plant has an economic
life of 5 years and is expected to produce Unlevered Net Income of Rs. 2500 million per year.
After 5 years, the fixed assets will fetch Rs. 575 million. The cost of capital for the project is 12

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Session 25 Practice Problems FAC633
percent. Assume that the straight line method of depreciation is used for tax as well as reporting
purposes. Derive the value of new plant using EVA method.

4. Consider the following details pertaining to a portfolio managed by Mr. Roopesh Singh and the
benchmark associated with the portfolio. Using attribution analysis, calculate selection effect and
allocation effect for the portfolio under consideration. All things considered, did Roopesh add
value through his selection skills, his allocation (timing) skills, or both?

Weights
Policy Actual
(benchmark) Portfolio
40% stocks 55% stocks
60% bonds 45% bonds
Returns
Index Actual
(benchmark) Portfolio
9% stocks 10% stocks
4% bonds 8% bonds

5. An investor holds 73,000 units of a bond whose features are summarized in the following table.
He wishes to be hedged against a rise in the interest rates.

Modified
Maturity
Coupon Rate YTM Duration (in Price
(in years)
years)
15 6% 8% 9.1844 82.71

Characteristics of the hedging instrument, which is a bond here, are as follows.

Modified
Maturity (in
Coupon Rate YTM Duration (in Price
years)
years)
20 6.25% 8% 10.411 82.68

Coupon frequency and compounding frequency are assumed to be semi-annual. YTM curve is
flat at 8% level.

a. What is the quantity of the hedging instrument the investor has to sell?

b. Should the yield curve increase instantaneously by 0.1%, what happens to the bond portfolio
if it is hedged? What happens to the bond portfolio if it is not hedged?
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