:Solve the following.
a) Explain the theory of purchasing power parity . Based on this theory, what is a general forecast of the values of currencies in countries with high inflation?
b) Today's spot rate of the Ghana Cedi is $0.22. Assume that purchasing power parity holds.
The U.S. inflation rate over this year is expected to be 5 percent, while Ghana inflation over this year is expected to be 9.8 percent. E5 Company Ltd is a Ghanaian company and it plans to import from United States and will need 20 million US dollars in 1 year.
Determine the expected amount of cedis to be paid by the E5 Company Ltd for the US dollars in 1 year.
xvi) a) Explain the international Fisher effect (IFE) theory.
Explain why the IFE may not hold.
b) Assume that the Australian dollar's spot rate is $.90 and that the Australian and U.S. one-year interest rates are initially 6 percent. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the U.S. one-year interest rate remains unchanged. Using this information and the international Fisher effect theory, forecast the spot rate for one year ahead.
c) According to the IFE, what is the underlying factor that would cause such a change in interest rate in (b) above? If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain.
32. Fast Track, a local bus company providing direct service between New York and Boston, had after-tax earnings of $2.5 million in the past year (year 0) and expected the same earnings forever. An investment bank had valued Fast Track at $20 million. Now by allowing passengers to book online, Fast Track expects its after-tax earnings to grow at 2.5% per year, starting this year (year 1). How much would the value of Fast Track increase by this change? (Assume the cost of capital stays the same.) 33. Dragon and Tiger Island (DTI), an online game company, expects next year's after tax earnings to be $20 per share. Its business is still expanding. It plows back 80% of its earnings. The ROE on its new investments is 15%. Its cost of capital is 12.5%. (a) What is the share price of DTI? What is its PVGO? (b) Suppose that a new competitor comes in and cuts DTI's ROE to 12%. How would this impact DTI's investment decisions and its share price? Explain why. 34. The dividend yield for shares of the Union Pacific Railroad is 1.9%. Security analysts are forecasting rapid growth in Union Pacific's earnings per share (EPS), about 12.7% per year for the next three years. Does that imply an expected rate of return of 1.9 + 12.7 = 14.6%? Explain. 35. The Northern Company is a utility company with existing assets that generates an EPS (earnings per share) of $5. If the firm only maintains existing assets, EPS is expected to remain constant at $5 a year. However, next year, the Northern Company has the opportunity to invest $3 per share to develop a new electricity generator using solar energy. The development of the new generator will be completed next year. This investment is expected to generate a return (ROE) of 20% per year forever. The cost Fall 2008 Page 34 of 66 of capital is 10%. What will be the Northern Companys share price if it decides to develop the new generator? Use the back of this page if needed to complete your answer. 36. Beta Trend is an exact match for MetaTrend except for one thing: it generates a con- tinuous stream of earnings and dividends. Thus it generates earnings in a continuous stream at 12% per year, starting immediately, and pays out half of earnings as divi- dends. What is the present value of Beta Trend stock? The annually compounded cost of capital is 12%.41. Refer to Table 2. {a} What was the quoted ask price (in dollars] for the 8.753 of 2020'? Assume par value = $10,000. You can ignore accrued interest. (b) What cash ows would you receive ifyou bought this bond on August 13, 2006 and held it to maturity? Specify mounts and timing {by month]. (c) Suppose you buy 310 million (par value) of the 4.125s of 2008 and sell short $10 million [par value} of the 3.255 of 212m. You hold each trade until the bend matures. What cash ows would you pay or receive? Specify amounts and timing. You can ignore any fees or margin requirements for the short sale. Table 2: Treasury Prices and Yields, August 3. 2006 Inl Ashamed Bonds and Notes: 3. 25 4 .125 5. 0 5. 75 4 3T5 l 2.5 3. 75 6 .125 Stripe: 42. Refer again to Table 2. {a} What were the l._ 2, 3, 4. 6 and 10-year soot interest rates? {b} What was the forward interest rate from August 2(1)? to August 2008'? From August m to August 2010'? (c) The 8.753 of August 2020 will pay a coupon in August 2010. What was the PV of this payment in August. 2113'? [d] iJirl'llat did the slope of the term structure imply about future interest rates? Ex- plain briey. Fall 2008 Page 20 of 63 Express your answers to (a) and (b) as effective annual interest rates. 43. Refer again to Table 2. Use the quoted yield on the August 2012 note to calculate the present value for the cash payments on the August 2012 note. AsSume that the rst note coupon comes exactly six months after August 13. 2006. Note: The quoted yields are rounded. Your PV may not match the Asked Price exactly. 44. In August 2006 you learn that you will receive a $10 million inheritance in August 2111?. You have committed to invest it in 'Il-easury securities at that tinie. but worry that interest rates may [all over the next year. Assume that you can buy or sell short any of the Treasuries in Table 2 at the prices listed in the table. {a} How would you lock in a one-year interest rate from August 2007 to August 2W3? What transactions would you make in August 2000'? Show how the transactions that lock in the rate. (b) Suppose you wanted to lock in a 5-year interest rate from August 2007 to August 3012'. How does your answer to part a change? 2. Solow-Swan Model (4 marks). You will demonstrate the importance of diminishing returns to capital in the Solow-Swan model. Draw a Solow-Swan diagram in which there are constant returns to capital. This would happen if the production function were Y = AK. Furthermore, assume that the sum of population growth and the depreciation rate is less than the saving rate. Does the economy converge to a steady state in this case? To answer this question, you should draw a Solow-Swan diagram in terms of output per person, as we did in class. Use this diagram to explain why the economy converges to a steady state or not,Solow-Swan Model (6 marks). (a) You will demonstrate the importance of diminishing returns to capital in the Solow-Swan model. Draw a Solow-Swan diagram in which there are constant returns to capital. This would happen if the production function were Y, = AK, where A = 1. Furthermore, assume that the sum of population growth and the depreciation rate is greater than the saving rate. Does the economy converge to a steady state in this case? To answer this question, you should draw a Solow-Swan diagram in terms of output per person, as we did in class. Use this diagram to explain why the economy converges to a steady state or not. (b) Assume, instead, that the sum of population growth and the depreciation rate is equal to the saving rate. Are there steady states? If yes, what are the steady states capital per person? (Note: A Diagram is not needed for this part.)
