Attribution Non-Commercial (BY-NC)

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ACF1002-1-2006-2

Attribution Non-Commercial (BY-NC)

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You are on page 1of 6

LEVEL IV 29 MAY 2007

INSTRUCTIONS TO CANDIDATES

NO. OF QUESTIONS SET : SIX (6)

NO. OF QUESTIONS TO BE ATTEMPTED : FOUR (4) -

SECTION A IS COMPULSORY, ANY TWO (2) QUESTIONS FROM

SECTION B AND ANY ONE (1) QUESTION FROM SECTION C

SECTION A (COMPULSORY)

USE SEPARATE ANSWER BOOKS FOR EACH SECTION.

Part I

Company. The stocks of the two companies have the following possible returns :

Plum Company

-0.1 0.1

-0.05 0.05

0.1 0.2

0.2 0.65

Widget Company

Possible Rate of Return Probability

-0.9 0.1

-0.4 0.05

-0.3875 0.2

0.5 0.65

(i) Calculate the expected rates of return of the stocks of Plum Company and

Widget Company. [2 marks]

(ii) Without doing any calculations, explain which of the two stocks is riskier.

[5 marks]

(iii) Calculate the standard deviations of the stocks of Plum Company and

Widget Company. [5 marks]

(iv) A rational investor will buy stocks from Plum Company or Widget

Company? Explain. [3 marks]

Part II

Portfolio II

Page 2 of 6

Portfolio I

Assets Return (%) Deviation (%)

Stock A 0.25 20 30

Stock B 0.75 12 15

Portfolio II

Assets Return (%) (%)

Stock C 0.75 12 15

Stock D 0.25 20 30

The correlation coefficient between the returns of stocks A and B (rAB) is equal to

-0.5 and the correlation coefficient between the returns of stocks C and D (rCD) is

equal to -1.

(i) Without doing any calculations, by analyzing the data that has been

provided for the two portfolios, which portfolio among portfolios I and II

should have the lowest level of risk? [5 marks]

(ii) Calculate the expected rate of return of portfolios I and II. [2 marks]

(iv) By using the answers obtained in sections (i) and (ii), explain which

portfolio a rational investor would choose. [3 marks]

Page 3 of 6

SECTION B

USE SEPARATE ANSWER BOOKS FOR EACH SECTION.

Part I

ABC Company is selling for Rs75. The company plans to pay a dividend of Rs7.50

per share each at the end of first and second years and Rs9 and Rs15 respectively

at the end of third and fourth years. The rate of return is equal to 12% and the

share’s price at the end of fourth year is Rs70.

Part II

Company. He is considering the following two scenarios :

constant rate of 4% indefinitely.

- Second scenario : the dividend will grow at a high rate of 12% per year

for the first three years; a medium rate of 7% for the next three years and

then at a constant rate of 4% indefinitely.

The last year’s dividend per share is Rs3 and the current market price of the share

is Rs60. The investor’s required rate of return is equal to 10%.

(i) Calculate the value of the share under the first scenario. [3 marks]

(ii) Calculate the value of the share under the second scenario. [6 marks]

(iii) By considering the two scenarios, explain under which scenario the

investor would be willing to buy the shares of Automobile Company.

[3 marks]

Page 4 of 6

Question 3 [20 marks]

(i) An individual has bought a zero-coupon bond that has a maturity of three

years. At maturity date the bondholder obtains a repayment of Rs1000. If

the yield to maturity of the bond is equal to 9%, calculate the price of the

bond. [4 marks]

(ii) Advice Company has issued a bond with annual coupon rate equal to 8%

and the fixed-interest bond offers a semi-annual coupon payment equal to

Rs40. The bond has a maturity of 3 years.

- Calculate the actual value of the bond if the market interest rate is

equal to 8.4%. [8 marks]

rational investor buy the bond? [3 marks]

(iii) A bond has nominal value of Rs100; it pays a coupon rate of 5% and has a

maturity of 2 years. If the market price of the bond is equal to Rs98 and it is

assumed that the bond is fairly priced, calculate the yield to maturity of the

bond. [5 marks]

investment of Rs 22000 and cash inflows would be equal to Rs 7000 per year

for 5 years. The company has a cutoff year of 3 years.

- Will the company accept the project? Explain the decision taken by

the company. [3 marks]

- By comparing the cost of capital with the IRR (rate of return of the

project), determine whether the company will accept the project.

Explain the decision taken by the company. [3 marks]

(iii) Compare the answers obtained in sections (i) and (ii) of this question;

which of the two investment appraisal methods will enable the company to

take a better investment decision? Explain why. [5 marks]

Page 5 of 6

SECTION C

(i) “Financial market is efficient if the market prices fully reflect all available

information at all instants.” (Fama 1970)

Explain what you understand from the above quotation. [7 marks]

(ii) Give two forms of market efficiency and for each form of market efficiency,

give a test that can be used to verify the particular form of market

efficiency. [8 marks]

(i) Explain the difference between direct finance and financial intermediation.

[3 marks]

(ii) What are the two main categories of securities that are exchanged in capital

markets? [2 marks]

(iii) For each category of security, give two examples of securities found in each

category. [4 marks]

(iv) Give the general characteristics possessed by the securities found in the two

categories. [6 marks]

Page 6 of 6

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