ADMS 4501 Lecture Notes - Lecture 20: Explained Variation, Basis Point, Futures Contract

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jadeleopard821

31 Mar 2017

School

York University

Department

Administrative Studies

Course

ADMS 4501

Professor

Lois King

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Document Summary

The least risky asset for a person investing for her child"s college tuition is a fixed instrument with a maturity approaching the time of the anticipated university education; in this case, it would be from 15 to 20 years. Given the horizon, a conservative stock portfolio, in particular an index security, would also serve to protect against inflation and have sufficient time to afford normal returns. This is an immunization strategy that provides a future value equal to (or greater than) the pension obligation, regardless of the direction of change in interest rates. Note that immunization requires periodic rebalancing of the bond portfolio: the least risky asset for a defined benefit pension fund that pays inflation- protected benefits is a portfolio of inflation linked bonds. Canadian governments are called real return bonds while the u. s. issues treasury inflation-protected securities, or tips. You would advise them to exploit all available retirement tax shelters, such tax- free savings accounts.

Related Questions

You are a managing partner of a prestigious investmentcounseling firm that specializes in individual rather thaninstitutional accounts. The firm has developed a nationalreputation for its ability to blend modern portfolio theory andtraditional portfolio methods. You have written a number ofarticles on portfolio management and you are considered anauthority on the subject of establishing investment policies andprograms for individual clients tailored to their particularcircumstances and needs.

Dr. and Mrs. A.J. Mason have been referred to your firm and toyou in particular. At your first meeting on August 1, 2012, Dr.Mason explained that he is an electrical engineer and long-timeprofessor at a local university. He is also an inventor and, after30 years of teaching, the right to one of his patented inventionshas just been acquired by a new electronics company, ACS, Inc.

In anticipation of the potential value of his invention, Dr.Mason has followed his accountantâs advice and established aprivate corporation, wholly owned by the Masons to hold the titleto the patented invention. It was this privatecorporation that sold the right to Dr. Masonâs invention to ACS,Inc. ACS, Inc. has agreed to pay $1 million in cash, payable at theclosing on September 30, 2012, for the right to Dr. Masonâsinvention. In addition, ACS, Inc. has agreed to pay royalties toDr. Masonâs private corporation on its sales of systems thatutilize the invention.

While all parties are optimistic about prospects for success,they are also mindful of the risks associated with any new firm,especially those exposed to the technological obsolescence of theelectronics industry. The management of ACS, Inc. has indicated toDr. Mason that he might expect royalties of as much as $100,000 inthe first year of production and maximum royalties of as much as$500,000 annually thereafter.

During your counseling meeting Mrs. Mason expressed concern forthe proper investment of the $1 million initial payment. Shepointed out that Dr. Mason has invested all of their savings intohis inventions. Thus, they will have only their Social Securityretirement benefits and a small pension from the local universityto provide for their retirement. Dr. Mason will be 65 at September30, 2013. His salary from the local university is currently $55,000per year and he does not expect this amount to change between nowand his planned retirement on his 65th birthday. After retirementDr. Mason expects to continue earning $10,000 - $25,000 annuallyfrom consulting and speaking engagements. The expectedSocial Security benefits are expected to be $1,800 per monthbeginning in October, 2013 and the annual pension from the localuniversity is expected to be $15,000 per year beginning at the sametime.

Assuming the royalty payments from ACS, Inc. are equal to$100,000 in the first year and an average of $300,000 per yearthereafter, the Masons are planning to help with the education oftheir six grandchildren. The grandchildren range in age from 8 to12 years old. In addition, the Masons wish to establish ascholarship fund in the name of Dr. Mason at the local universitythat would provide $5,000 per year to one selected electricalengineering student. This scholarship should be self- sustainingwith its own investments.

Both Dr. and Mrs. Mason have strongly indicated during the firstappointment that they are conservative investors and want a minimumrisk of any losses.

Requirements

You and your fellow partners are to present a proposal thatspecifically meets the retirement investment objectives of theMasons listed below. Your proposal should be from 4 â 6 pagesdouble spaces, Times Roman 12 pt. In addition, your team shouldinclude a cover page listing each member of your team and aseparate list of any references used in preparing the proposal. Theproposal must follow APA rules in structure and presentation.

Dr. & Mrs. Masonâs Retirement InvestmentObjectives

*Provide $65,000 of withdrawals from the investment account eachyear. This amount will be in addition to the university pension andSocial Security received each year.

*Minimize income tax.

*Include at least three types of investments.

*Provide for active management of the portfolio with an annualfee of 1% - 1 Â½% of value in the investment portfolio.

*Provide an annual growth after all withdrawals and fees of 4% -5%.

*Provide funding for the six grandchildrenâs education that willtotal $40,000 each when they reach the age of 18.

*Provide for a continuing scholarship at the local university inthe amount of $5,000 per year.

The goal of the firm is to ____ because _____. Answer maximize shareholders' wealth; it considers all risks invest funds in real estate; the return is longer maximize shareholders' profit; it is a short term outlook closely matching management goals Mike is paying $8,000 a year on his mortgage at 6% nominal annual interest. He has 15 more years to make payments. He wants to sell his house today. The lowest [minimum] price he can sell the house without losing any money on the house would be about ___. Answer $120,000 $ 50,000 $77,698 $ 186,208 A firm's net income before tax, EBT [NIBT] (on the income statement) is affected by _____. Answer taxes interest dividends Common Stock as listed on the Balance Sheet could include which of the following? Answer A) retained earnings B) additional paid in capital over par value C) preferred capital Both A) and B) If an asset is sold for ___ than its basis, the tax effect would be ____. Answer A) more; capital gain and depreciation recapture B) less; depreciation recapture C) more; capital loss Both A) and B) The main reason for a firm to have assets is to _______. Answer generate revenue match the liabilities and equity both of the above be able to borrow money and pay its debts none of the above The only risk you would NOT have in loaning money to the United States Government (Uncle Sugar) is _____ risk. Answer liquidity maturity default A(n) ____ shows _____. Answer balance sheet; sources and uses of funds income statement; net income as of a specific date cash flow statement; how well the firm is doing relative to its competition You can compare dollars _____ because ______. Answer computed using equations; any math is always correct at any point in time; time is never a factor if they are at nominal value; that is when decisions are made only at the same point in time; dollars can be invested to earn interest There ___ a tax benefit to the company with paying preferred dividends because _______. Answer is; investors can write them off is not; investors declare them as income is; the company can use the payments as an expense is not; the company cannot use the payments as an expense XYZ issued a 6% coupon, $1,000 par, 30 year to maturity bond. It is now 6 years to maturity. What is the price of the bond if the yield to maturity [market interest rate] is 10%? Answer $1,000 $659.46 $825.79 $705.33 The valuation process can be described as ______. Answer calculating the present value of an expected future cash flow using the investor's required rate of return as the discount rate calculating the future value of an expected future cash flow using the investor's required rate of return as the discount rate amortizing the value of the asset over its holding period The ______ is the minimum required rate of return a firm must earn on its investments. Answer net present value opportunity cost of capital or weighted average cost of capital. internal rate of return gross profit margin The value of an asset is the _____ dollar price someone is willing to pay for it. Answer usual maximum minimum Companies use ____ in capital budgeting project analysis because ________. Answer accounting profit; that is the total net income after tax cash flow; that is what the owners would receive from the project and reinvest accounting profit; that is what the owners would receive from the project and reinvest after tax cash flow; that is the result of prudent accounting When borrowing money, you want to know the ____ interest rate because ____. Answer nominal; it is the easiest to find. effective; it is the true cost of borrowing risk free; that is what the government pays Fed funds; that is what you would pay the bank Cash available to pay out to the investors after the firm pays for new investments or additions to working capital is _____. Answer a statement of cash flows operating after tax cash flow free cash flow net income An organization that raises money from investors and provides financing for individuals and businesses is a ___. Answer factor federal government regulatory unit state government taxing authority financial intermediary Negatives/cons of the Net Present Value (NPV) technique include: Answer least conservative reinvestment assumption multiple rates of return for non-conventional cash flows all of the above none of the above A fixed exchange rate means a country _____. Answer can only use gold coins as money is limited in the amount of paper money it can print can print money as the economy demands Your company is considering an investment with the following expected cash flows: Initial Investment = $407,596 Operating Cash Flows = $73,428 per year Terminal Cash Flow = $11,872. The company's WACC is 11% for similar risk projects. The proposed project would have an expected life of 9 years. Your boss asks you to do the analysis. You would tell your boss this proposed project ___ because ____. Answer is acceptable; NPV is about $3,620 is acceptable; NPV is zero should be rejected; NPV is about -$5,660 [negative $5,660]. should be rejected; NPV is zero All ratios are ___ and a reason to analyze ratios is ____. Answer good; to continue to look productive good and bad; because seemingly good ratios can be masking something bad bad; to try to rework the numbers to have them look good basically irrelevant; there really is no need to analyze financial statements When analyzing financial statements, ratio analysis gives ____ and provides insight into ____. Answer very little useful information; practically nothing good practice in logical thinking; what has occurred and the logic behind it financiers something to do during slow periods; how the financier spends his time accountants a reason to provide financial statements; why accountants do what they do while at work Given: Economic State[i]: Good Average Expected Return[i]: 10% 8% Probability[i]: 30% 70% What is the Standard Deviation? Answer 3% 8.4% 0.92% 5.6% Chapter 9: XYZ has a projected project to install a new press. The expected cash revenue is $175,000 per year. Expected yearly expenses are: Operatinf costs of $50,000; Rental of $17,000; Utilities of $20,500; and Depreciation of $10,000. The tax rate is 35%. What is the expected After-Tax Operating Cash Flow for the first year? Answer $65,500 $60,375 $77,500 $97,500 A stock just paid a dividend of $1.60 per year. The dividend is expected to grow at 3% per year indefinately. Equally risky stocks offer expected rates of return of 8%. What should be the stock price? Answer 53.33 $16.00 $32.96 None of the above. A plot of the CAPM is the _____. Answer wrong thing to do Security Market Line a function showing how to calculate TVM All of the above. Derivatives are used to ___. Answer divide one number by another find old ways to do things hedge risk none of the above With the end of the Gold Standard in the 1970's, what new risk did business face in the international market? Answer Comjpetition Exchange rate Worker compensation Property taxes One of the positive aspects [pros] of a Floating Exchange Rate System is ____. Answer money can be printed as needed to support financial/economic growth no/reduced inflation economic growth is reduced as a result of reduced liquidity [lower money supply] business planning is more difficult A(n) ____ contract obligates the seller to execute the contract and the contract is executed. Answer backwards forward future option What policies did countries institute after the Great War that help lead to the Great Depression? Answer A. Mandatory military service B. Trade restrictions C. High tariffs D. Isolationism Only B., C. and D. All of the above

bluemarten153

QUESTION 1

In the lease versus buy decision, leasing is often preferable

	A.	because the lessee owns the property at the end of the least term.
	B.	because lease obligations do not affect the firm's risk as seen by investors.
	C.	because, generally, no down payment is required, and there are no indirect interest costs.
	D.	because it has no effect on the firm's ability to borrow to make other investments.
	E.	because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.

2 points

QUESTION 2

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

True

False

2 points

QUESTION 3

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

True

False

2 points

QUESTION 4

Which of the following statements is CORRECT?

	A.	If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
	B.	If a stock has a negative beta, its expected return must be negative.
	C.	A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
	D.	According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
	E.	A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.

2 points

QUESTION 5

Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases."

True

False

2 points

QUESTION 6

The owner of a convertible bond owns, in effect, both a bond and a call option.

True

False

2 points

QUESTION 7

If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

True

False

2 points

QUESTION 8

Which of the following statements is most CORRECT?

	A.	Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
	B.	One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
	C.	The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
	D.	Warrants have an option feature but convertibles do not.
	E.	The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.

2 points

QUESTION 9

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

True

False

2 points

QUESTION 10

The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners.

True

False

2 points

QUESTION 11

Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

True

False

2 points

QUESTION 12

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

True

False

2 points

QUESTION 13

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

True

False

2 points

QUESTION 14

Operating leases help to shift the risk of obsolescence from the user to the lessor.

True

False

2 points

QUESTION 15

Starting to invest early for retirement increases the benefits of compound interest.

True

False

2 points

QUESTION 16

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

True

False

2 points

QUESTION 17

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

True

False

2 points

QUESTION 18

An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

True

False

2 points

QUESTION 19

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

True

False

2 points

QUESTION 20

If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

True

False

2 points

QUESTION 21

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

True

False

2 points

QUESTION 22

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

	A.	Project C, which is of above-average risk and has a return of 11%.
	B.	Project A, which is of average risk and has a return of 9%.
	C.	None of the projects should be accepted.
	D.	All of the projects should be accepted.
	E.	Project B, which is of below-average risk and has a return of 8.5%.

2 points

QUESTION 23

To finance the construction of a new plant, Pietersen Corporation must raise an additional $10,000,000 of equity capital through the sale of common stock. The firm currently has an EPS of $5.40 and a P/E ratio of 10, with 1,200,000 shares outstanding. If the firm wants its ex-rights price to be $50, what subscription price must it set on the new shares?

	A.	$39.28
	B.	$50.00
	C.	$29.55
	D.	$41.80
	E.	$33.78

2 points

QUESTION 24

Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

	A.	A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage.
	B.	A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
	C.	The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity.
	D.	If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.
	E.	Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

2 points

QUESTION 25

Which of the following statements is CORRECT?

	A.	In the statement of cash flows, a decrease in inventories is reported as a use of cash.
	B.	In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.
	C.	In the statement of cash flows, depreciation charges are reported as a use of cash.
	D.	In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
	E.	Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.

2 points

QUESTION 26

The term "additional funds needed (AFN)" is generally defined as follows:

	A.	A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
	B.	Funds that are obtained automatically from routine business transactions.
	C.	Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
	D.	The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
	E.	The amount of assets required per dollar of sales.

2 points

QUESTION 27

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True

False

2 points

QUESTION 28

Which of the following statements is CORRECT?

	A.	The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
	B.	Identifying an externality can never lead to an increase in the calculated NPV.
	C.	Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
	D.	An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase.
	E.	An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

2 points

QUESTION 29

Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

True

False

2 points

QUESTION 30

A warrant is an option, and as such it cannot be used as a "sweetener."

True

False

2 points

QUESTION 31

BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

	A.	The life of the option is increased, i.e., the time until it expires is lengthened.
	B.	The exercise price of the option is increased.
	C.	The Federal Reserve takes actions that increase the risk-free rate.
	D.	BLW's stock price becomes more risky (higher variance).
	E.	BLW's stock price suddenly increases.

2 points

QUESTION 32

Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

	A.	$48.62
	B.	$40.00
	C.	$42.00
	D.	$46.31
	E.	$44.10

2 points

QUESTION 33

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price?

	A.	$18.29
	B.	$17.39
	C.	$19.22
	D.	$18.75
	E.	$17.84

2 points

QUESTION 34

If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth.

True

False

2 points

QUESTION 35

The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

	A.	$783.75
	B.	$744.56
	C.	$825.00
	D.	$866.25
	E.	$707.33

2 points

QUESTION 36

Which of the following statements is CORRECT?

	A.	If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
	B.	If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
	C.	If a coupon bond is selling at par, its current yield equals its yield to maturity.
	D.	If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
	E.	If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.

2 points

QUESTION 37

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

True

False

2 points

QUESTION 38

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

	A.	Project S's NPV is more sensitive to changes in WACC than Project L's.
	B.	If the WACC is 13%, Project S will have the lower NPV.
	C.	If the WACC is 6%, Project S will have the higher NPV.
	D.	If the WACC is 10%, both projects will have positive NPVs.
	E.	If the WACC is 10%, both projects will have a negative NPV.

2 points

QUESTION 39

A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

True

False

2 points

QUESTION 40

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

	A.	Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.
	B.	Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
	C.	Corporations generally find it relatively difficult to raise large amounts of capital.
	D.	Corporations generally face relatively few regulations.
	E.	Corporate investors are exposed to unlimited liability.

2 points

QUESTION 41

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

True

False

2 points

QUESTION 42

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio?

	A.	Use cash to reduce accruals.
	B.	Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
	C.	Use cash to reduce accounts payable.
	D.	Borrow using short-term notes payable and use the proceeds to reduce accruals.
	E.	Use cash to reduce short-term notes payable.

2 points

QUESTION 43

ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.

True

False

2 points

QUESTION 44

High current and quick ratios always indicate that a firm is managing its liquidity position well.

True

False

2 points

QUESTION 45

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

True

False

2 points

QUESTION 46

"Capital" is sometimes defined as funds supplied to a firm by investors.

True

False

2 points

QUESTION 47

Heavy use of off-balance sheet lease financing will tend to

	A.	affect a company's cash flows but not its degree of risk.
	B.	make a company appear less risky than it actually is because its stated debt ratio will appear lower.
	C.	make a company appear more risky than it actually is because its stated debt ratio will be increased.
	D.	affect the lessee's cash flows but only due to tax effects.
	E.	have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

2 points

QUESTION 48

As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

True

False

2 points

QUESTION 49

On the balance sheet, total assets must always equal total liabilities and equity.

True

False

2 points

QUESTION 50

The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity.

True

False

ADMS 4501 Lecture Notes - Lecture 20: Explained Variation, Basis Point, Futures Contract

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