MGTB09 2011 Fall Assignment 2 Due Date: December 1, 2011 Show your steps.

Question 1 (25 marks) Considering two mutual exclusive projects: A and B. Project A requires initial investment of $2,000 and pays cash flow of $500 per year for seven years. Project B requires initial investment of $1,800 and pays $3,400 at the end of month 54. The annual discount rate is 12%. (a) Calculate the payback period, discounted payback period, IRR, PI, and NPV for both projects. (b) If we have to repeat the project forever, which project you will choose?

Question 2 (25 marks) KIT Inc. is planning to launch a new product, priced at $10 per unit. The unit cost is $4. The sale volume is 1,000 units in the first year and increases by 100 units per year for the next five years. To begin, KIT has to pay $2,000 (tax deductible) to clean up the site. The production requires an initial investment in equipment of $15,000. The equipment is in an asset class with a CCA rate of 20% and it is the only asset in the class. At the end of year six, the equipment will be sold for $4,000 and KIT has to pay $1,000 (tax deductible) to restore the site. The net working capital is expected to be 20% of the following years sales. Half of the total net working capital will be recovered when the production halts at the end of year 6 and the remaining half at the end of year 7. The tax rate is 30% and KITs cost of capital is 15%. Calculate the net present value.

Question 3 (25%) The following table shows the probabilities and the possible returns on Assets A and B: States Good Bad Probability 0.3 0.7 Asset A 0.16 0.05 Asset B 0.05 0.16

a. Calculate the expected returns and standard deviations of Assets A and B. b. Calculate the correlation between Asset A and Asset B. c. What must be the risk-free rate? d. If the Market portfolio has an expected return of 12.5% and both Assets A and B are fairly priced, what are the betas of Assets A and B?

Question 4 (25 marks) Consider the following returns of Asset A and the Market under different GDP growth: GDP growth = 5% 30% 9% 12% GDP growth = 10% 40% 16% 18% GDP growth = 15% 30% 18% 24%

Probability Asset A return Market return (a) (b) (c) (d)

Calculate the expected return and standard deviation of asset A and the Market. Calculate the beta of asset A. Find the risk-free rate if asset A is fairly priced. If asset B has -1 correlation with asset A and standard deviation of 0.985%, find the expected return of asset B. (e) Construct a portfolio that consists of assets A and B, and has standard deviation of 2%. Calculate the expected return of this portfolio.

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