accounting ;REVIEW QUESTIONS 1. CALCULATING RETURNS a. The stock of Dynamic Company went from Gh25 to Gh28 last year. The firm also paid 50 pesewas in dividends. Compute the holding period return b. In the following year, the dividend was raised to 70 pesewas. However, a bear market developed towards the end of the year and the stock price declined from GH28 to GH22. Compute the rate of return (or loss) to shareholders c. Assume the real rate of return in the economy is 5.0%, the expected rate of inflation is 10% and the risk premium is 5.9%. Compute the risk-free rate and required rate of return 2. BOND PRICING a. Given a 15-year bond that originally sold for GH1,000 with an 11% coupon rate, what would be the price of the bond if interest rates in the marketplace on similar bonds are now 12%. Interest is paid semiannually. Assume a 15-year time period b. What would be the price if interest rates go down to 8%? (Once again, do semiannual payments for 15 years. 3. LOOK AT THE OPTION PRICE QUOTES FOR IBM a) What is the closing price of IBM shares? b) What is the highest strike price listed? c) What is the price of a 118 Call option? d) What is the price of a 119 Put Option? e) What is the intrinsic value of the 118 call? f) What is the total premium? g) What is the speculative premium? CASES ASSIGNMENT OF CASES CASE No Title GROUPS RESPONSIBLE 1 Janet Ricardo 1 6 11 2 The Bonsus 2 7 12 3 P/E Ratio Analysis 3 8 13 4 Hedging 4 9 14 5 Looking for the Right Stock 5 10 15 1. JANET RICARDO CONSIDERS INVESTMENT CORRELATIONS Janet Ricardo is considering investing in the construction industry. She believes the industry will do well over time but realizes that the short-run performance may not be spectacular. Janine has narrowed her investment selection to three possible investments: (1) Home Builders (HBI) , a company that constructs single-family detached homes; (2) Home Repairs (HRI), company specializing in home remodeling and repair projects; and (3) National Tool Company (NTC), a firm that manufactures tools used in the construction industry. Janet thinks a robust economy bodes well for both HMI and NTC, to varying degrees, but poorly for HRI. Although Janine's investment strategy is to hold a portfolio over time, rather than to frequently trade securities, she is concerned about excessive variations in portfolio value. Before investing, she plans to analyze the portfolio implications of the three companies. Accordingly, she also has developed probability estimates for changes in the economy for the upcoming year. Additionally, she has estimated returns from the three companies, given changes in the economy. Her data appear in the following table. Weak Average Strong Expected Return Variance Standard Deviation Coefficient of Variation Probability 0.25 0.5 0.25 HBI -0.2 0.18 0.44 0.15 0.0521 0.228254 1.521695 HRI 0.12 0.08 0.04 0.08 0.0008 0.028284 0.3535534 NTC -0.32 0.16 0.56 0.14 0.0972 0.311769 2.2269225 a) Explain why Janine probably should not invest in NTC. b) Using the calculation of expected return, variance, standard deviation, and coefficient of variation for HBI and HRI, discuss which is the riskier. c) Suppose that Janet decides to invest 90% of her funds in HRI and 10% in HBI. Calculate the expected return for this portfolio. d) Janet believes she has a reasonable tolerance toward risk and describes herself as a moderate risk averter. Suppose that in the upcoming year, Janet could invest in a savings account guaranteed to pay a sure return of 8% for the year. Considering your work in question (c) above, what advice might you offer Janet? Explain. 2.0 THE BONSUS FACE REINVESTMENT PROBLEMS Kofi and Karen Bonsu are a married couple in their mid-30s with two children. Their combined incomes of GHc180,000 (Ghc 15,000/month) provides for a comfortable living, but they face substantial costs when their children begin university in 10 years. They have about GHc40,000 to invest now and are considering investing in fixed- income securities. Kofi thinks that they should limit their portfolio to 10-year, zero coupon issues with yields to maturity of about 20.5%. Karen disagrees. She thinks the portfolio should include coupon bonds with Yield to Maturity of about 22%. Her bonds have a BBB rating, while Kofi's are AAA-rated. Karen believes Kofi is too conservative. She argues that if interest rates fall, as each expects will happen, her strategy will be better because she will have locked in the higher rates. She also thinks her strategy is better if, by some chance, interest rates rise; in that event, the larger losses will be with Kofi's zeros. The Bonsus have some liquidity apart from the GHc40,000 earmarked for the children, but it is not considerable. They would like your advice on the matter. Before meeting with them, you have gathered yield data for selected Treasury issues: 91-day bills 12.0 5-year notes 15.0 10-year bonds 18.0 20-year bonds 19.5 a) What will the bond portfolio be worth 10 years from now if Kofi's approach is followed? Is it possible to know what it will be worth if Karen's approach is followed? Explain. b) Do you think that Karen has a correct risk perspective on their investment problem? Has she actually locked in higher rates? Discuss. c) Does it seem likely that interest rates will fall in the future? Discuss your conclusion. How important to the Bonsus investment objective are interest rate movements? Explain. d) How would you advise the Bonsus? If you prefer Kofi's or Karen's approach, explain why. 3.0 P/E RATIO ANALYSIS Mr. Sanders of Prime-Time Investment Company is evaluating the P/E Ratio of Delta Consumer Electronics (DCE). The firms P/E Ratio is currently 20. With earnings per share of $2, the stock price is 40. The average P/E in the consumer electronics industry is presently 19. However, DCE has an anticipated growth rate of 15% versus 10% for the industry norm so 2 will be added to the industry P/E by Mr. Sanders. Also, the operating risk associated with DCE is less than that for the industry because of its long-term contract with Sears. For this reason, Mr. Sanders will add another factor of 1 to the industry P/E ratio. The debt-to-total-assets ratio is not as encouraging. It is 50 percent, while the industry ratio is 40 percent. In doing his evaluation, Mr. Sanders decides to subtract a factor of 0.5 from the industry P/E ratio. Other ratios, including dividend payout, appear to be in line with the industry, so Mr. Sanders will make no further adjustment along these lines. However, he is somewhat distressed by the fact that the firm only spent 3 percent of sales on R&D last year when the industry norm is 5 percent. For this reason he will subtract a factor of 1 from the industry P/E ratio. Despite the relatively low research budget, Mr. Sanders observes that the firm has just hired two of the top executives from a competitor in the industry. He decided to add a factor of 0.5 to the industry P/E ratio because of this. a) Determine the P/E ratio for DCE based on Mr. Sanders' analysis. b) Multiply this times earnings per share and comment on whether you think the stock might possibly be under- or overvalued in the marketplace at its current P/E and price. 4.0 HEDGING Farmer William Cropley anticipates taking 100,000 bushels of oats to the market in four months. The current cash price for oats is $1.29. He can sell a four-month futures contract for oats at $1.33. He decides to sell ten 5,000-bushel futures contracts at that price. Assume in four months when Farmer Cropley takes the oats to market and also closes out the futures contracts (buys them back), the price of oats has tumbled to $1.15. a) What is his total loss in value over the three months on the actual oats he produced and took to market? b) How much did his hedge in the futures market generate in gains? c) What is his overall net loss considering the answer in Part (a) and the partial hedge in Part (b)? 5.0 LOOKING FOR THE RIGHT STOCK Rob Dexter is a conservative investor who is greatly concerned with preservation of capital. However, he does seek growth as an investment objective. Two companies have come to his attention lately, and he is considering investing in one of them. Both are in the same industry. Consider the following ratios and recommend one of the companies to Rob, explaining the reasoning for your selection. Fleet, Inc. Dirge, Inc. Current ratio 1.8 1.9 NWC/sales 0.5 0.6 Debt ratio 0.6 0.3 Debt/equity ratio 1.5 0.4 ROI 8% 10% ROE 20% 14% Times interest earned 4.5 7.2 10-year growth rates: Earnings per share 15% 12% Dividends per share 17% 11% Price of common stock 14% 9% Current share price of stock $50 $99 Last year dividend per share $2 $6 Beta 1.5 0.8 Risk-free rate = 8% Market risk premium = 8.5%