Question:

A

For each of the below, indicate True or False. explanation is required.

a) Given: At t = 0 you bought a 3-year, 9% coupon bond with a 7% YTM. You held the position until t = 3. Each coupon that was received prior to t = 3 was reinvested and rolled over at a 7% interest rate. Statement: The realized compound yield on the investment was 7%.

b) Given: At t = 0 you bought a 4-year zero coupon bond with a 9% YTM. Two years later you sold the bond when it was trading at a 12% YTM. Statement: The realized compound yield on your two-year investment was somewhere between 9% and 12%.

c) Given: At t = 0 a 10-year zero coupon bond had an 8% YTM. You bought the bond at t = 2 when it had 8 years left to maturity and was trading at a 7% YTM. You sold the bond 3 years later when its YTM was greater than 7%. Statement: Your realized compound yield from t = 2 to t = 5 was less than 7%.

d) Given: From t = 3 to t = 4 the price of a risk free bond increased, and its YTM also increased. Statement: The coupon rate on this bond must be less than the YTM. (Hint: think of the pull-to-par graph and think of whether the statement would be possible for a bond with a coupon rate greater or equal to its YTM.)

e) As a general rule, if one expects interest rates are going to surprise to the upside, it would be wiser to invest in longer term bonds.

Topic: Bond Pricing and Bond Arbitrage

2) You are given the following information:

- Bond A is a 1-year, 6% coupon bond with face value $8,000 and YTM = 4%

- Bond B is a 2-year, zero coupon bond with face value $30,000 and YTM = 6%

- Bond C is a 3-year, 7% coupon bond with face value $20,000 and YTM = 7%

- Bond D is a 4-year, zero coupon bond with face value $8,000 and YTM = 9%

- Bond E is a 5-year, zero coupon bond with face value $2,000 and YTM = 11%

2

- A financial institution is offering the following product: ? the client pays the financial institution $200,000 at t = 0 and another $100,000 at t = 1 ? the financial institution pays the client $40,000 at t = 2, X at t = 3, and $60,000 at t = 4

a) What would X have to be in order for the product to be fairly priced? (Hint: bootstrap the yield curve and then set PV(client cash flow to bank ) = PV(bank cash flow to client).

b) Suppose a financial institution is offering the above product, but the payment at t = 3 is $100 greater than your answer to part a. You are a Hedge Fund manager. Describe how you would crea-te an arbitrage by buying 1 unit of the product from the financial institution and trading the various bonds listed above at t = 0 (you may not have to trade all of them). Specify how many units of each bond you will buy or sell. Construct the arbitrage so that your profit is realized at t = 0.

c) Based on your strategy in part b, what is the magnitude of the arbitrage profit at t = 0?

d) Repeat part b, but this time construct the arbitrage in such a way that the profit is realized at t = 3. Hint: in this case your inflow = outflow conditions should hold for t = 0, 1, 2 and 4.

e) Based on your strategy in part d, what is the magnitude of the arbitrage profit at t = 3?

f) What is the relationship between your answers to parts c and e?

......

Scenario:

Superior Living, Inc. is a private, domestic U.S. manufacturer of home furniture targeted at U.S. consumers ages 21 to 54 (from first-time apartment renters to empty nesters). The company generates $250 million in revenues from six product lines: outdoor patio, luxury, durable rental, children's furniture, rare woods, and space saver. The company sells its products through a number of retailers and has a solid business reputation with distributors and customers. Superior Living has divisions for each of the product lines, and each division includes sales, marketing, and manufacturing personnel. The other functional areas?human resources, finance, and information technology?support the entire company. You are the vice president of finance, reporting to the chief financial officer (CFO). Your role includes the responsibility for financial analysis and financial reporting. This includes developing financial statements, monitoring performance metrics, educating the senior officer team on key financial decisions, and valuing new business opportunities that are presented to the board of directors. Superior is looking to go public in the next 6 to 8 months with an initial public offering (IPO). In addition, the company is aggressively pursuing new business opportunities, which may include expansion via acquisition and the development and implementation of new product lines. All of this will require the company to manage its finances extremely well. You are the key officer to lead in this responsibility. The CFO has asked you to meet with her to outline the financial plans for the next 12 months. She needs you to develop the three financial statements for the end of the fiscal year, determine the capital investments required for the upcoming year, develop the operating budget, and outline the plan for the IPO. To d-o this, you will work closely with the VP of accounting and the head of strategic planning. You know that the next 12 months can determine the long-term success of Superior. The CEO and board of directors have made it clear to you and the CFO that the financial plans for the next year should be based on sound, fundamental financial principles and contain as little risk as possible. Finally, you understand the company very well and know that the division chiefs?the senior vice presidents who lead the product divisions?wield a great deal of power and must agree to financial plans. Many of them have expressed that they will need significant expenditures next year, stating that the "running rate will not be enough," referencing the company's longstanding process of developing expense budgets based on the previous year's expenditures plus a small percentage increase. Furthermore, they all have stated that if a merger should occur, it should be with a product line that compliments their division and is brought under their control.

TASK: 5-6 Parag

After looking at the project and talking with some people that have been around the organization for many years, you recognize that the 10% cost of capital is not reflective of the company's current cost of capital. The head of treasury has assured you that the company can raise debt at 7% in today's market and that if the firm was not going to use the US$4M to invest in the machine for the production plant, it would be invested in some short-term securities yielding 5%.

With this in mind, explain a company's cost of capital and how it is calculated. What is marginal cost of capital and how does it differ from weighted average cost of capital? How do market rates and the company's perceived market risk impact its cost of capital? Assume you are leading a discussion on these elements with the managers and finance personnel.

1. Baxter Bros. is a manufacturing company that has two major divisions. Both divisions have required a significant investment, and management wants to compare their performance. Below is information related to the two divisions. Division A Division B Sales $30,000 $40,000 Expenses $25,000 $35,000 Asset investment $100,000 $100,000 Management is confused that the ROI seems to be the same for both divisions, and wants a deeper evaluation. Which division generates greater profitability per sales dollar?QUESTION 1 Suppose that an investment management firm has been hired by XYZ Corporation to work on a new stock issue that the company is planning to offer. The investment management firm's brokerage unit, where John is the head, has a "sell" recommendation on XYZ, but the head of the investment banking department, Jack, has asked John to change the recommendation from "sell" to "buy". What should John do? Increase the recommendation by no more than one increment (in this case to a "hold" recommendation. Assign a new analyst to reevaluate the company and decide if the stock deserves a higher rating. Place the stock on a restricted list and stop issuing any investment recommendations and give only factual information about the company Increase the recommendation to "buy" as Jack suggested. Do nothing until the investment-banking unit finalizes the dissemination of the initial prospectus of the XYZ to gauge the investors' interest on the stock.Question 44 2 pts The SEC is a governmental institution responsible for preventing securities violations. It also regulates certain investment management firms, such as mutual funds, under the Investment Act of 1940 to promote accurate financial reporting. What does SEC stand for? O Single Equity Control. O Securities and Economic Commission. None of these. Single Equity Cooperation. O Securities and Exchange Commission.QUESTION 36 Impact first investment implies that: O Social and environmental considerations take precedence over financial returns O The beneficiaries of this style of investment management have no concern about financial returns O Investors are being irrational in accepting that they may make a lower return in exchange for greater social and environmental impact O All of the above