CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS

A mining company is considering a new project. Because the mine has received a permit, the project would be legal; but it would cause significant harm to a nearby river. The firm could spend an additional $9 million at Year 0 to mitigate the environmental Problem, but it would not be required to do so. Developing the mine (without mitigation) would cost $51 million, and the expected cash inflows would be $17 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $18 million. The risk-adjusted WACC is 14%.

1. Calculate the NPV and IRR with mitigation. Round your answers to two decimal places. Do not round your intermediate calculations. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55.
   NPV $ million
   IRR %

   Calculate the NPV and IRR without mitigation. Round your answers to two decimal places. Do not round your intermediate calculations. Enter your answer for NPV in millions. For example, an answer of $10,550,000 should be entered as 10.55.
   NPV $ million
   IRR %

2. How should the environmental effects be dealt with when this project is evaluated?

   1. The environmental effects if not mitigated could result in additional loss of cash flows and/or fines and penalties due to ill will among customers, community, etc. Therefore, even though the mine is legal without mitigation, the company needs to make sure that they have anticipated all costs in the "no mitigation" analysis from not doing the environmental mitigation.
   2. The environmental effects should be ignored since the mine is legal without mitigation.
   3. The environmental effects should be treated as a sunk cost and therefore ignored.
   4. The environmental effects if not mitigated would result in additional cash flows. Therefore, since the mine is legal without mitigation, there are no benefits to performing a "no mitigation" analysis.
   5. The environmental effects should be treated as a remote possibility and should only be considered at the time in which they actually occur.

3. Should this project be undertaken?
   -Select-Even when mitigation is considered the project has a positive IRR, so it should be undertaken.The project should not be undertaken under the "no mitigation" assumption.The project should be undertaken only under the "no mitigation" assumption.The project should not be undertaken under the "mitigation" assumption.Even when mitigation is considered the project has a positive NPV, so it should be undertaken.

   If so, should the firm do the mitigation?

   1. Under the assumption that all costs have been considered, the company would mitigate for the environmental impact of the project since its IRR with mitigation is greater than its IRR when mitigation costs are not included in the analysis.
   2. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its NPV with mitigation is greater than its NPV when mitigation costs are not included in the analysis.
   3. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its IRR without mitigation is greater than its IRR when mitigation costs are included in the analysis.
   4. Under the assumption that all costs have been considered, the company would mitigate for the environmental impact of the project since its NPV with mitigation is greater than its NPV when mitigation costs are not included in the analysis.
   5. Under the assumption that all costs have been considered, the company would not mitigate for the environmental impact of the project since its NPV without mitigation is greater than its NPV when mitigation costs are included in the analysis.

A corporate bond pays interest twice a year and has 18 years to maturity, a face value of $1,000 and a coupon rate of 5.6%. The bond's current price is $1,359.59. It is callable starting 12 years from now (years to call) at a call price of $1,106.

What is the bond's (annualized) yield to call?

EXPECTED RETURNS

Stocks A and B have the following probability distributions of expected future returns:

1. Calculate the expected rate of return, r_B, for Stock B (r_A = 13.20%.) Do not round intermediate calculations. Round your answer to two decimal places.
   %

2. Calculate the standard deviation of expected returns, σ_A, for Stock A (σ_B = 18.62%.) Do not round intermediate calculations. Round your answer to two decimal places.
   %

3. Now calculate the coefficient of variation for Stock B. Round your answer to two decimal places.

4. Is it possible that most investors might regard Stock B as being less risky than Stock A?

   1. If Stock B is less highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be more risky in a portfolio sense.
   2. If Stock B is more highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be less risky in a portfolio sense.
   3. If Stock B is more highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.
   4. If Stock B is more highly correlated with the market than A, then it might have the same beta as Stock A, and hence be just as risky in a portfolio sense.
   5. If Stock B is less highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.

You have observed the following returns over time:

Assume that the risk-free rate is 4% and the market risk premium is 6%.

1. What is the beta of Stock X? Do not round intermediate calculations. Round your answer to two decimal places.

   What is the beta of Stock Y? Do not round intermediate calculations. Round your answer to two decimal places.

2. What is the required rate of return on Stock X? Do not round intermediate calculations. Round your answer to one decimal place.

   %

   What is the required rate of return on Stock Y? Do not round intermediate calculations. Round your answer to one decimal place.

   %

3. What is the required rate of return on a portfolio consisting of 80% of Stock X and 20% of Stock Y? Do not round intermediate calculations. Round your answer to one decimal place.

   %

Consider the following information for three stocks, Stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Stock Expected Return Standard Deviation Beta

A 8.01 % 15 % 0.7

B 10.16 15 1.2

C 11.88 15 1.6

Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

a. What is the market risk premium (rM - rRF)? Round your answer to two decimal places. %

b. What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

c. What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places. % d.

Would you expect the standard deviation of Fund P to be less than 15%, equal to 15%, or greater than 15%?

I. less than 15%

II. greater than 15%

III. equal to 15%

Consider the following information for three stocks, Stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

1. What is the market risk premium (r_M - r_RF)? Round your answer to two decimal places.

%

2. What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

3. What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

%

4. Would you expect the standard deviation of Fund P to be less than 15%, equal to 15%, or greater than 15%?
   1. less than 15%
   2. greater than 15%
   3. equal to 15%

_____IIIIII

Provide Sue with financial advice on which option has the potential to yield the highest monetary value. Support your rational with calculations using time value of money and comment on the risk return relationship for each option, assume interest rate on savings is 4% and is compounded semi-annually.

Sue James is a 55-year old accountant who works at Ernst and Young (EY) who is about to retire. She has the following decision to make:

Option A – Select a lump sum gratuity payment of $120,000 with a reduced pension of $1,750 per month.

Option B – Select a monthly pension of $3,300 with no lump sum gratuity payment.

In addition, Sue has a loan of $72,000 with loan payments of $1,200 per month for the next five years.

1. State whether it's possible to initiate the following positions with zero initial cost; consider that option premiums received may offset option premiums paid, and briefly explain why it is or is not possible for each.

a. Bear & Bull Call Spreads.

b. Bear & Bull Put Spreads.

c. Box Spread.

d. Butterfly Spread.

Write a brief summary of the explantation of the shape of the term structure of interest rates: The Pure Expectations Theory

Today is your first day at the investment banking firm of Dewey, Cheatum and Howe. They have offered you a choice between two different compensation arrangements. You can have a salary of $95,000 per year for the next two years, or you can have a salary of $84,000 per year for the next two years and a signing bonus $20,000 that is paid today. The bonus is paid immediately and the salary is paid in equal amounts at the end of each month. If the interest rate is 8 percent compounded monthly, which compensation program do you prefer? Explain why. If the interest rate is 18 percent compounded monthly, which compensation program do you prefer? Explain why. do not use excel or a calculator to solve

You are considering an investment that will pay you $3,000 for the next five years. That is, there will be five cash flows of $3,000, but the cash flows are paid at the beginning of the year. • Your opportunity cost of capital (r ) is 7.75%  Using the present value formula calculate the present value of each of the cash flows by 1. Discounting cash flows using annual compounding 2. Discounting cash flows using monthly compounding 3. Discounting cash flows using continuous compounding • How much would you be willing to pay for the investment using each of the three different compounding scenarios? That is, what is the present value of the cash flows from the investment using each of the three different compounding scenarios? Do not use excel or a calculator to solve

A two-year coupon-paying bond has a face value of $100 000, yield of 7.5% p.a. and coupon rate of 7.5% p.a. The interest rates are paid half yearly.

a) Calculate the price of the bond

b) Calculate the duration of a bond

c) Calculate the convexity of the bond.

d) The yield on the bond instantaneously increases from 7.5% to 7.7%.

*Please write down the formula instead of Excel format

In the following year, there is a 10% chance of a bear market, a 20% chance of a bull market, and a 70% chance of a neutral market.
Debt will return -2%, 5%, and 5% in the bear, bull and neutral market, respectively.
Equity will return -15%, 15%, and 8% in the bear, bull and neutral market , respectively .

What is the expected return of debt in %?  (round to 1 decimal place)

What is the volatility of equity in %? (round to 1 decimal place)

What is the covariance of debt and equity? (leave as a decimal; round to 5 decimal places)

What is the correlation of debt and equity?   (leave as a decimal; round to 3 decimal places)

What is the expected return of a risky portfolio made up of 70% bonds and 30% stock?  (units of %; round to 2 decimal places)  

What is the volatility of a risky portfolio made up of 70% bonds and 30% stock?    (units of %; round to 1 decimal places)   


What is the Sharpe ratio of the risky portfolio made up of 70% bonds and 30% stock? (round to 2 decimal places)

A hedge fund manager has a portfolio worth $50 million with a beta of 1.25. The manager is concerned about the performance of the market over the next two months He plans to uses three-month stock market index futures to hedge his market exposure. The current stock market index level is 2,500 and one contract is on 250 times the futures price. The continuously compounded interest rate is 3% and the dividend yield on the stock market index is 2%.

a) What is the fair futures (forward) price today?

b) What position should the fund manager take to hedge his market exposure?

c) Calculate the effect of the hedging strategy on the fund manager’s return if the index in two months is 2,250, 2,500, or 2,750. (Hint: For each scenario, compute the fair forward price with one month maturity left and same interest rate and dividend yield. Then, you can compute the total profits or losses he incurs on his hedging position.)

You are considering an investment that will pay you $1,200 in one year, $1,400 in two years, and $1,600 in three years, $1,800 in four years, and $11,000 in five years. All payments will be received at the end of the year. • Your opportunity cost of capital (r ) is 10.5% • Using the present value formula calculate the present value of each of the cash flows by 1. Discounting cash flows using annual compounding 2. Discounting cash flows using monthly compounding 3. Discounting cash flows using continuous compounding • How much would you be willing to pay for the investment using each of the three different compounding scenarios? That is, what is the present value of the cash flows from the investment using each of the three different compounding scenarios? • Which of the three present values is the largest (annual, monthly or continuously compounded returns)? Please explain why this is the case. do not use a calculator or excel to solve