University of California

Walter A. Haas School of Business

UGBA 103
Introduction to Finance
Prof. Dmitry Livdan 25 October 2017

Solutions to the MIDTERM

1. (10 points) Two years ago you have bought SISCO stock for $100 per share. You have used
growing perpetuity formula to value it
D−1
P−2 = ,
r−g
where you have assumed a constant annual growth rate of dividends, g. Right now after
paying a dividend per share D0 = $2, SISCO trades at P0 = $106.09 and its dividends
continue to grow at the same rate g. You are thinking about selling SISCO next year and
plan to earn an annual return of 12% on the transaction. At what price, P1 , do you have to
sell SISCO one year from now to justify such return?
The price of SISCO grows at the same rate g as the dividends do:
 1  1
2 P0 2 $106.09 2
P0 = P−2 (1 + g) ⇒ g = −1= − 1 = 0.03
P−2 $100

Therefore we know that D1 = $2 ∗ 1.03 and that the ex-dividend price of SISCO today is
equal to
D1 + P1
P0 = ⇒ P1 = P0 (1 + r) − D1 = $106.09 ∗ 1.12 − $2 ∗ 1.03 = $116.76.
1+r

2. (15 points) Suppose you are running a cab business and your current cab is expected to
produce a cash flow of $4,000 in one year and $3,000 in two years all in nominal terms. After
that it will have to be replaced. The resale value in real terms is $1,000 if you replace now,
$500 next year, and $200 in year 2. The nominal APR is 6% and the inflation is 1% and you
can use r = R + i. The best alternative is a new cab that will be optimally replaced every 3
years, giving the following nominal cash flows:

Cash Flows
C0 C1 C2 C3 PV at 6%
−P 7,000 7,000 12,000 −P + 24, 283.73

What is the minimum price P of the new cab such that you will replace the old cab in year
2? You can calculate the price either in nominal (year 0) or real (year 2) dollars. (Assume
no taxes.)
UGBA 103 MIDTERM – Solutions 2

We calculate the real APR first

R = r − i = 6% − 1% = 5%.

Next, we need to convert the CFs for the new cab into EACFs:
EACF 1 P
−P + 24, 283.73 = [1 − ] ⇒ EACF = − + 9, 084.78.
0.06 1.063 2.673
This EACF is in nominal dollars. Next, lets convert the resale values into nominal terms.
RV0 = $1, 000 since at t = 0 all values are nominal ones. RV1 = $500(1 + 0.01) = $505 and
RV2 = $200(1 + 0.01) = $202.
If we replace today we will get 1,000 in year 0, and EACF in subsequent years while if we
replace in year 1 we will get 0 in year 0, 4,505 in year 1 and EACF in subsequent years. If P
is large enough (and we are looking for large P’s) then 4,505 is greater then EACF + 1, 060
in year 1 (where we invested 1,000 for one year at 6%) and we are not going to replace the
cab today. If we replace the cab in year 2, we have to compare 4,505 vs 4,000 in year 1 and
EACF vs 3,202 in year 2. Equivalently, we can invest 505 for one year at 0.06% and compare
EACF + 535.30 and 3,202 in year 2. The break-even price will be
P
EACF + 535.30 = 3, 202 ⇒ − + 9, 084.78 + 535.30 = 3, 202 ⇒ P = 17, 155.61
2.673

3. (10 points) You are considering investment into two different projects, A and B. You expect
things to be either good next year with probability 23 or bad with the probability 31 . If things
will be good, the project A will pay $21M and the project B will pay $15M one year from
now. If things will be bad, the project A will pay $9M and the project B will pay $24M one
year from now.

(a) (4 points) Which project is riskier?

The average value of the project A is
2 1
E[VA ] = $21M + $9M = $17M,
3 3
while the variance of the project is:
2 1
V ar(VA ) = ($21M − $17M )2 + ($9M − $17M )2 = 32M 2 ,
3 3
p
leading to std(VA ) = V ar(VA ) = $5.66M . The average value of the project B is

2 1
E[VB ] = $15M + $24M = $18M,
3 3
while the variance of the project B is:
2 1
V ar(VB ) = ($15M − $18M )2 + ($24M − $18M )2 = 18M 2 ,
3 3
p
leading to std(VB ) = V ar(VB ) = $4.24M , thus making the A project riskier.
UGBA 103 MIDTERM – Solutions 3

(b) (6 points) Is there a risk-free portfolio of projects A and B? If yes, please calculate the
portfolio weights.
Let us calculate the covariance between two projects
2 1
Cov(VA , VB ) = ($21M −$17M )($15M −$18M )+ ($9M −$17M )($24M −$18M ) = −24M 2 .
3 3
The total variance of the portfolio with wA invested in the project A is equal to:
2
V ar(wA VA +(1−wA )VB ) = wA V ar(V1 )+(1−wA )2 V ar(V2 )+2wA (1−wA )Cov(VA , VB ) =
2
= 32wA + 18(1 − wA )2 − 48wA (1 − wA ) = 0.
3
Solving a quadratic equation for wA yields wA = 7 and wB = 47 .