UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

May 2, 2006 Davydenko/Derrien/

MGT337Y FINAL EXAMINATION Florence/Kan/Puffer

SOLUTIONS

1. (a) Since the price of a stock is the present value of its future dividends and there is
only one more dividend left for both stocks, we have

DIVA DIVA 12
PA = ⇒ E[RA ] = −1= − 1 = 0.34,
1 + E[RA ] PA 8.955
DIVB DIVB 10
PB = ⇒ E[RB ] = −1= − 1 = 0.065.
1 + E[RB ] PB 9.389

(b) As there are only two risky stocks in the economy, the expected return of the
market portfolio is

1 10
E[RM ] = xA E[RA ] + xB E[RB ] = × 0.34 + × 0.065 = 0.09.
11 11
By the CAPM, we have

E[RA ] − RF = βA (E[RM ] − RF )
E[RA ] − RF
⇒ βA =
E[RM ] − RF
0.34 − 0.04
⇒ βA =
0.09 − 0.04
⇒ βA = 6.

Similarly,

E[RB ] − RF
βB =
E[RM ] − RF
0.065 − 0.04
⇒ βB =
0.09 − 0.04
⇒ βB = 0.5.

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 (c) Let w be the fraction of the investor’s wealth that is invested in the market portfolio,
and 1 − w be the fraction of his wealth that is invested in the risk-free asset. For the
portfolio to have an expected return of 6.5%, we must have

E[Rp ] = wE[RM ] + (1 − w)RF

⇒ 0.065 = 0.09w + 0.04(1 − w)
⇒ w = 0.5.

Therefore, the investor should invest 21 of his money in the risk-free asset, 1
2
× 1
11
= 1
22
of his money in stock A, and 21 × 10
11
= 115
of his money in stock B.
(d) Among all the portfolios of stocks A and B, the only portfolio that has an expected
return of 6.5% is the one that invests 100% in stock B. This portfolio cannot be on
the capital market line since any portfolio that is on the capital market line must
be a combination of the risk-free asset and the market portfolio. Therefore, unless
the investors choose to invest in just the risk-free asset (which is not the case here),
portfolios on the capital market line must contain some nonzero weights in stock A.
(e) The standard deviation of the market portfolio is given by
h i1
σM = x2A σA2 + x2B σB2 + 2xA xB ρAB σA σB 2

" 2 2 #1
1 10 1 10 2
   
2 2
= (0.05) + (0.06) + 2 (0.5)(0.05)(0.06)
11 11 11 11
1
= (0.00324) 2
= 0.057.

Therefore, the Sharpe ratio of the market portfolio is given by

E[RM ] − RF 0.09 − 0.04

SR(M ) = = = 0.878.
σM 0.057

2. (a) Using a 12% discount rate, the NPV of Plans A and B are

NPVA = −14 + 5A40.12 = −14 + 5 × 3.037 = 1.187m.,

NPVB = −16.5 + 6A40.12 = −16.5 + 6 × 3.037 = 1.724m.

If 12% is the appropriate discount rate for both plans, then Plan B would be preferred
to Plan A as it has a higher NPV.
(b) For Plan A, using r = 16%, NPVA = −14 + 5A40.16 = −0.009m. For Plan B, using
r = 17%, NPVB = −16.5 + 6A40.17 = −0.04m. Therefore, at these rates, both projects
have roughly zero NPV. Based on IRRs, Plan B is preferred to Plan A as it has a
higher IRR.

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 (c) The beta for Plan A is 0.75 × 0.6 + 0.25 × 1.4 = 0.8. The beta for Plan B is
0.5 × 0.7 + 0.5 × 1.75 = 1.225. Plan B is riskier and has a higher required rate of return
than Plan A. The required rates of return are calculated using the CAPM as follows:

rA = RF + βA (E[RM ] − RF ) = 0.05 + 0.8 × (0.12 − 0.05) = 0.106,

rB = RF + βB (E[RM ] − RF ) = 0.05 + 1.225 × (0.12 − 0.05) = 0.13575.

(d) Using the discount rates from part (c), the NPV of Plans A and B are

NPVA = −14 + 5A40.106 = −14 + 5 × 3.129 = 1.646m.,

NPVB = −16.5 + 6A40.13575 = −16.5 + 6 × 2.939 = 1.136m.

Based on NPVs, Plan A is preferred to Plan B as it has a higher NPV.

(e) It is important that when we compute the NPV, we should use the risk-adjusted
discount rate for each project but not the same discount rate for every project. There-
fore, the NPVs computed in part (a) are inappropriate. Part (b) suggests that Plan B
has a higher IRR than Plan A. However, part (d) suggests Plan A has the higher NPV
using risk-adjusted discount rates, so this is the better plan. Mutually exclusive plans
must be ranked using NPVs, not IRRs. When IRR and NPV rank mutually exclusive
plans differently, NPV rankings must be used as they are consistent with maximization
of shareholders’ wealth.
(f) IRR and NPV conflicts arise because IRR assumes interim cash flows can be rein-
vested at the IRR. NPV assumes that interim cash flows can be reinvested at the cost
of capital, which is more reasonable. Ranking conflicts tend to arise when plans vary
in size or cash flow timing. In addition, the IRR approach ignores the riskiness of the
plans. In this example, plan A is less risky than plan B and when the cash flows from
plan A are discounted at the lower rate, the larger NPV for A becomes apparent.

3. (a) With both corporate taxes and personal taxes, the value of the levered firm can be
expressed in terms of an unlevered firm as
" #
(1 − TC )(1 − TS )
VL = VU + 1 − B.
1 − TB

Since TC = 0.3, TS = 0.1 and TB = 0.37, we have (1−TC )(1−TS ) = (1−0.3)(1−0.1) =

0.63 = 1 − 0.37 = 1 − TB , we have VL = VU . Therefore, based on tax considerations,
investors are indifferent between equity or debt financing. The existence of bankruptcy
costs would argue against the use of debt, since the use of debt increases the chance
that such costs will be incurred, and there are no offsetting benefits in this scenario.
(b) The author of the article expects interest rates will fall in response to a slowing
economy. However, he expects short-term interest rates to fall much further than
long-term interest rates which will restore the shape of the yield curve to its normal

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 state of upward sloping. This means that investors who invest in short-term bond will
face reinvestment risk because they may have to reinvest at lower rates in the future.
In addition, they also face the risk of missing opportunities to gain from investing in
long-term bond, as the prices of long-term bonds will have risen substantially when
long-term rates fall.
4. (a) This is a covered call strategy. A covered call is an option strategy with which you
can sell a call against the share that you already own. Basically, if you had a stock
in your portfolio that you would not mind selling for a certain price, you could then
write a call against it. For writing such a call, you would receive the amount of an
option premium from the buyer of your options contract. In our case, you will receive
$300 for the calls you wrote against your shares. The following diagram illustrates the
combined payoffs of the 100 stocks and the 100 calls that you write at maturity.
Value of Portfolio at Maturity
2100

1800

1500
Portfolio Value

1200

900

600

300

0
0 5 10 15 20 25 30
Stock Price at Maturity
(b) This strategy benefits the investor relative to owning the stock only if the stock
price falls and the option is “out of the money.” If the stock price falls, the investor
collects the premium of $3 which will partially offset the loss from the stock price drop.
However, if the stock price rises, the investor has given up all the upside potential.
Although the investor has additional protection from losses when the price falls, this
is not free since they lose the upside.
(c) If the stock price is $19, the option is “in the money” for the buyer, so the seller
(writer) of the option has to deliver the stock to the option buyer at a price of $15, and
has received the premium of $3. The net payoff to the covered call is $15 + $3 = $18

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 per share or $1800 for 100 shares, but this is $100 less than if the call had not been
written.
(d) This is a “protective put” strategy that you might pursue if you thought there was
a risk the stock price might fall by more than the premium of $3, but you still wanted
to benefit if the stock price rose. The payoff of such startegy is given in the following
diagram
Value of Portfolio at Maturity
3000

2500

2000
Portfolio Value

1500

1000

500

0
0 5 10 15 20 25 30
Stock Price at Maturity

(e) By the put-call parity, we have

c(15) = p(15) + S − PV(15) = p(15) + 15 − PV(15).

Therefore, we must have c(15) > p(15). As both the call and the put are selling at $3,
the call is underpriced relative to the put. In order to take advantage of this arbitrage
opportunity, we just need to buy the call, lend $15, sell the put, sell the stock. This
portfolio costs us nothing today, but it will give us max[S ∗ − 15, 0] + 15(1 + r) − S ∗ −
max[15 − S ∗ , 0] = 15r at maturity, where r is the interest rate.

5. (a) We can solve this problem by two different approaches.

Replicating Portfolio
Consider forming a portfolio of ∆ shares and borrowing an amount of B. Next year,
the stock price can be either Su = $126 or Sd = $114. If the stock price goes up,
the payoff of the call is $4. If the stock price goes down, the payoff of the call is $0.

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Therefore, for this portfolio to replicate the payoffs of the call, we need

126∆ − 1.03B = 4,
114∆ − 1.03B = 0.

Solving the two equations, we have ∆ = 1/3 and B = 36.8932. The cost of this
portfolio is 1/3 × $120 − $36.8932 = $3.1068. By no arbitrage, the price of the 1-year
European call should also be $3.1068.
Risk Neutral Probability
Let p be the risk-neutral probability for the stock price to go up. In a risk-neutral
economy, p must satisfy
p × $136 + (1 − p) × $114
= $120 ⇒ p = 0.8.
1.03
Therefore, the value of the call is
0.8 × $4 + 0.2 × $0
S= = $3.1068.
1.03

(b) The figure below summarizes the possible stock price movements in ABC.

 Suu =132.3
0.5



S =126 H
 u

 HH
0.5 
H
 0.5
HH
 H
H
S=120 HH

 Sud =119.7
0.5

HH
0.5 HH
H 

H
Sd =114 
HH
H
HH
0.5 HHH S =108.3
dd

At maturity, the payoffs of the puts can take three possible outcomes: puu = max[122−
Suu , 0] = 0, pud = max[122 − Sud , 0] = 2.3, and pdd = max[122 − Sdd , 0] = 13.7. Again,
there are two methods to price the put.
Risk Neutral Probability
From the last part, we know the risk-neutral probability of the up-state is 0.8. One

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year before maturity, we have:

pu = (0.8puu + 0.2pud )/(1 + r)

= (0.8 × 0 + 0.2 × 2.3)/(1.03) = 0.4466,
pd = (0.8pud + 0.2pdd )/(1 + r)
= (0.8 × 2.3 + 0.2 × 13.7)/(1.03) = 4.4466.

Therefore, today’s price of the European put is:

p = (0.8pu + 0.2pd )/(1 + r)

= (0.8 × 0.4466 + 0.2 × 4.4466)/(1.03) = 1.2103.

Replicating Portfolio
year before maturity at the up state, we can replicate the payoffs of the put at maturity
by selling ∆u units of stock and lending an amount of Bu , where

−∆u Suu + Bu (1 + r) = puu ,

−∆u Sud + Bu (1 + r) = pud .

Solving, we have
pud − puu 2.3 − 0
∆u = = = 0.18254,
Suu − Sud 132.3 − 119.7
∆u Sud + pud 0.18254 × 119.7 + 2.3
Bu = = = 23.4466.
(1 + r) 1.03
Therefore,

pu = −∆u Su + Bu = −0.18254 × 126 + 23.4466 = 0.4466.

Similarly, at the down state, we have

pdd − pud 13.7 − 2.3
∆d = = = 1,
Sud − Sdd 119.7 − 108.3
∆d Sdd + pdd 1 × 108.3 + 13.7
Bd = = = 118.4466.
(1 + r) 1.03
Therefore,
pd = −∆d Sd + Bd = −1 × 114 + 118.4466 = 4.4466.
Today, we can replicate the payoffs of the put one year from now by selling ∆ units of
stock and lending an amount of B, where

−∆Su + B(1 + r) = pu ,
−∆Sd + B(1 + r) = pd ,

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 Solving, we have
pd − pu 4.4466 − 0.4466 1
∆ = = = ,
Su − Sd 126 − 114 3
1
∆Su + pu × 126 + 0.4466
B = = 3 = 41.2103.
(1 + r) 1.03

Therefore, the price of the European put today is

1
p = −∆S + B = − × 120 + 41.2103 = 1.2103.
3

(c) One year from today, the only situation in which early exercise is profitable is if
the stock price of ABC is $114. Early exercise in this case yields $8, which is more
than $4.4466. When we take this into account, the value of American put at today is
0.8 × Pu + 0.2 × Pd 0.8 × 0.4466 + 0.2 × 8
P = = = $1.90.
(1 + r) 1.03

At today, exercise the American put gives us $2, which is more than $1.90, so it is
optimal to exercise the American put today, and its price should be $2.
(d) From part (b), we know the theoretical price of the European put at the up-state
is 0.4466. If the actual price of the put is $1, the put is overpriced, so we should sell it.
In order to offset the exposure of writing the put, we should sell ∆u = 0.18254 share
and lend Bu = 23.4466. The combined payoffs of these three positions are

Cashflow Payoffs at Maturity

Position t=1 S2 = 119.7 S2 = 132.3
Write one put 1 −2.3 0
Sell 0.18254 share 23 −21.85 −24.15
Lend 23.4466 −23.4466 24.15 24.15
Total 0.5534 0 0

which gives us an arbitrage profit.

6. (a) Since the firm is all equity financed, the value of the equity and the value of the
firm are identical, and they are given by

VU = S = $343.75 × 10,000 = 3,437,500.

Also, its cost of equity and weighted average cost of capital are also identical and they
are given by
1,000,000 × (1 − 0.45)
WACC = r0 = = 0.16.
3,437,500

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 (b) Using MM Proposition I with corporate taxes, we have
VL = VU + TC B = 3,437,500 + 0.45 × 2,000,000 = 4,337,500.
The value of equity is then given by
S = VL − B = 4,337,500 − 2,000,000 = 2,337,500.
Using MM Proposition II with corporate taxes, we have the cost of equity of the levered
firm as
B 2,000,000
rS = r0 + (r0 − rB )(1 − TC ) = 0.16 + (0.16 − 0.10)(1 − 0.45) = 0.1882,
S 2,337,500
and its weighted average cost of capital is given by
B S
WACC = rB (1 − Tc ) + rS
VL VL
2,000,000 2,337,500
= × 0.10(1 − 0.45) + × 0.1882
4,337,500 4,337,500
= 0.1268.

(c) Since the equity holders benefit from the corporate tax shield of 0.45×$2,000,000 =
$900,000, the share price will go up by $900,000/10,000 = $90 to $343.75 + $90 =
$433.75. Therefore, the number of shares to be repurchased is 2,000,000/433.75 =
4,610.95.
(d) VL , S, rS and WACC all stay the same as in part (b). Although we have flotation
costs here, the amount of borrowing stays the same as in part (b), and so is the annual
tax savings. The only difference here is the share price will not go up by as much.
(e) The existing equity holders benefit from the corporate tax shield of $900,000 but
they need to pay $100,000 to the investment bank. Therefore, the share price will go
up by $800,000/10,000 = $80 to $343.75 + $80 = $423.75 and the number of shares to
be repurchased is 1,900,000/423.75 = 4,483.78.
7. (a) The after-tax return on share A is 0.1(1 − Td ) = 0.1 × (1 − 0.3) = 0.07. Let r∗ be
the annualized after-tax return on share B. For an investor with two-year investment
horizon, we have
(1 + r∗ )2 = (1.1)2 − [(1.1)2 − 1]Tg
⇒ (1 + r∗ )2 = (1.1)2 − [(1.1)2 − 1](0.3)
⇒ r∗ = 0.071.
For an investor with ten-year investment horizon, we have
(1 + r∗ )10 = (1.1)10 − [(1.1)10 − 1]Tg
⇒ (1 + r∗ )10 = (1.1)10 − [(1.1)10 − 1](0.3)
⇒ r∗ = 0.0778.

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(b) The annualized after-tax return of holding share A is 7%. For an investor with a
ten-year investment horizon, the annualized after-tax return of holding share B is r∗ ,
where
(1 + r∗ )10 = (1.1)10 − [(1.1)10 − 1]Tg .
For the investor to be indifferent between buying shares of A and B, we must have
r∗ = 0.07. This implies

(1.07)10 = (1 + r∗ )10
⇒ (1.07)10 = (1.1)10 − [(1.1)10 − 1]Tg
(1.1)10 − (1.07)10
⇒ Tg =
(1.1)10 − 1
⇒ Tg = 0.3932.

(c) Clientele effect refers to the fact that investors are not identical, they differ in terms
of their tax brackets and investment horizons. As a result, they have preferences toward
stocks with different characteristics. In particular, individuals in high tax brackets or
long investment horizon would prefer stocks with zero or low dividend payout ratio, and
individuals in low tax brackets or short investment horizon would prefer stocks with
higher dividend payout ratios. As an aggregate, companies will adjust their dividend
policy to satisfy different clienteles in the economy.
(d) This statement is likely to be false. As long as there are already enough high-
dividend paying firms to satisfy dividend-loving investors, firm B will not be able to
boost its share price by paying high dividends. A firm can boost its stock price only if
an unsatisfied clientele exists.

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