Corporate Finance 6 problem Assignment #4

FIN 6406 – Corporate Finance Len Lin

Spring 2017 FINAL EXAM Due: 11:59pm EST on 3/3/2017(Friday)

READ THESE INSTRUCTIONS!

1. This exam is worth a total of 100 points.

2. You should electronically submit your final exam with detailed calculations via email to zlin@fiu.edu. You will title the email “YOUR NAME – FINAL”. You will title the

document “YOUR NAME – FINAL”. You will put your name on a title page. Good

luck!

Problem 1 [10 points]

Stock

100

137

51

Bond (rF=2%)

100

102

102

Call (E=87)

C

50

0

1-year call option, S=100, E=87, rF=2% (annual)

1 step per year

How much should the call option worth?

2

Problem 2 [15 points]

If total return after tax on a certain project is 7.5%, and there are five financing choices available

to investors:

(1) 7% interest rate and a 60% LTV ratio;

(2) 7.8% interest rate and a 70% LTV ratio;

(3) 8.5% interest rate and a 80% LTV ratio;

(4) 9.25% interest rate and a 90% LTV ratio;

(5) 9.75% interest rate and a 95% LTV ratio;

Suppose that there are three types of investors (A, B and C) whose tax rates are 15%, 25% and

35%, respectively.

Questions:

(1) Find out the financing choice for each type of investor and the corresponding after-tax

return on equity.

(2) Which type of investor has the highest after-tax return on their equity?

3

Problem 3 [15 points]

You currently have $2,500,000. You want to invest it in the following three assets: 10-year US

Treasury bond with coupon rate 3.5%, Blandy and Gourmange stocks, who have the following

historical annual returns:

Your goal is to have the expected annual return of 7.2% with a minimum portfolio risk. How

much money should you allocate to these three assets?

Year Blandy Gourmange 1 26.0% 47.0%

2 15.0% -54.0%

3 -14.0% 15.0%

4 -15.0% 7.0%

5 2.0% -28.0%

6 -10.0% 40.0%

7 22.0% 17.0%

8 30.0% -23.0%

9 -32.0% -4.0%

10 28.0% 75.0%

11 28.6% 51.7%

12 16.5% -59.4%

13 -15.4% 16.5%

14 -16.5% 7.7%

15 2.2% -30.8%

16 -11.0% 44.0%

17 62.2% 18.7%

18 33.0% -25.3%

19 -35.2% -4.4%

20 50.8% 82.5%

21 23.4% 42.3%

22 13.5% -48.6%

23 -12.6% 13.5%

24 -13.5% 6.3%

25 1.8% -25.2%

26 -9.0% 36.0%

27 18.8% 15.3%

28 27.0% -20.7%

29 -28.8% -3.6%

30 25.2% 67.5%

4

Problem 4 [30 points]

A real estate investor has the following information on an apartment building:

 Purchase Price is $1,125,000 with acquisition costs of $35,000

 33,600 leasable square feet

 Initial rent of $1.5/sq. ft. per month and will increase at the beginning of each year for 5 percent per year. For example, the first year rent from month 1 to month 12 is

$1.5/sq. ft., the 2nd year rent from month 1 to month 12 is $1.575 ($1.5*(1+5%)), and

so on.

 Vacancy rate of 5% of gross rent per month.

 Operating expenses are 25% of effective gross income

 Three financing choices:

1. Mortgage with 75% LTV ratio, 20 years, monthly payments and 5% annual rate;

2. Mortgage with 80% LTV ratio, 20 years, monthly payments and 6% annual rate;

3. Mortgage with 85% LTV ratio, 20 years, monthly payments and 6.5% annual rate;

 Holding period is 3 years (36 months) and the capital improvement expenditure is assumed to be $20,000 at the end of the first year only (12 months).

 Expected increase in value is 50% in total when sold in year 3 (36 months), 5% selling expenses

 75% depreciable with monthly depreciation.

 Investor’s tax rate is 35%, and capital gain tax rate is 15%.

Questions:

1. Compute equity after-tax cash flows from month 1 to month 36 for each financing choice.

2. What is the equity after-tax annual return (internal rate of return) for each financing choice and which choice would you like to make?

5

Problem 5 [15 points]

Based on the Capital Asset Pricing Model (CAPM) and the diagram below, what is the return of

the stock if its beta is 1.5 or 0.5?

Problem 6 [15 points]

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the

required return is 12%.

E x

p ec

te d

re tu

rn

b

%5.3FR

%3

1

% 10

%12MR

Project A Project B

Year Cash flow Cash flow

0 -2500 -2500

1 900 50

2 800 600

3 1600 150

4 100 900

5 50 500

6 300 2500

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