Finance in a Nutshell

Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 1
Q1
Year Price D R
1994 $8.50 $0.25
1995 $12.00 $0.27 44.4%
1996 $16.48 $0.31 39.9%
1997 $24.46 $0.35 50.5%
1998 $34.00 $0.40 40.6%
1999 $51.58 $0.47 53.1%
2000 $47.94 $0.55 -6.0%
2001 $40.08 $0.64 -15.1%
2002 $24.35 $0.72 -37.5%
2003 $30.98 $0.76 30.3%
Q2
W0 I CP W1 EI W5 EI 5
$100 15% Annual $115.00 15.00% $201.14 101.14%
$100 15% Semiannual $115.56 15.56% $206.10 106.10%
$100 15% Quarterly $115.87 15.87% $208.82 108.82%
$100 15% Monthly $116.08 16.08% $210.72 110.72%
$100 15% Continuous $116.18 16.18% $211.70 111.70%
Q3
Year Price D r
1994 $8.50 $0.25
1995 $12.00 $0.27 36.7%
1996 $16.48 $0.31 33.6%
1997 $24.46 $0.35 40.9%
1998 $34.00 $0.40 34.1%
1999 $51.58 $0.47 42.6%
2000 $47.94 $0.55 -6.2%
2001 $40.08 $0.64 -16.3%
2002 $24.35 $0.72 -46.9%
2003 $30.98 $0.76 26.5%
The difference between R and r is large when price changes are large, and small when price changes are small
Q4
Year Price D R r Wealth
1994 $8.50 $0.25 $100.0
1995 $12.00 $0.27 44.4% 36.7% $144.4
1996 $16.48 $0.31 39.9% 33.6% $202.0
1997 $24.46 $0.35 50.5% 40.9% $304.1
1998 $34.00 $0.40 40.6% 34.1% $427.6
1999 $51.58 $0.47 53.1% 42.6% $654.6
2000 $47.94 $0.55 -6.0% -6.2% $615.4
2001 $40.08 $0.64 -15.1% -16.3% $522.7
2002 $24.35 $0.72 -37.5% -46.9% $327.0
2003 $30.98 $0.76 30.3% 26.5% $426.2
Multiperiod 326.2% 145.0%
The difference between R and r is large when price changes are large, and small when price changes are small
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 2
Q1
Year GM WalMart
1994 -22.00% -14.42%
1995 28.68% 5.56%
1996 8.61% 3.11%
1997 19.21% 74.72%
1998 21.30% 107.55%
1999 25.74% 70.45%
2000 -27.84% -22.79%
2001 -0.98% 8.94%
2002 -20.82% -11.76%
2003 52.85% 5.73%
AM 8.5% 22.7%
GM 5.5% 16.3%
The AM is always larger than or equal to the GM
Q2
Year GM-Return GM-Wealth WM-Return WM-Wealth
1993 $100.0 $100.0
1994 -22.00% $78.0 -14.42% $85.6
1995 28.68% $100.4 5.56% $90.3
1996 8.61% $109.0 3.11% $93.1
1997 19.21% $129.9 74.72% $162.7
1998 21.30% $157.6 107.55% $337.8
1999 25.74% $198.2 70.45% $575.7
2000 -27.84% $143.0 -22.79% $444.5
2001 -0.98% $141.6 8.94% $484.2
2002 -20.82% $112.1 -11.76% $427.3
2003 52.85% $171.4 5.73% $451.7
Q3
GE At AM $225.6
At GM $171.4
WM At AM $773.9
At GM $451.7
The correct terminal wealth is found by compounding at the GM
Q4
GE AM-GM 2.9%
AM/GM-1 53.1%
WM AM-GM 6.4%
AM/GM-1 39.5%
The differences are larger for WalMart because it has a higher volatility (SD)
Q5
Period Price Return Shares-1 CF-1 Wealth-1 Shares-2
1998 $10.70 50 -$535.0 $535.0 800
1999 $38.72 261.9% 100 -$3,872.0 $5,808.0 400
2000 $27.88 -28.0% 200 -$5,576.0 $9,758.0 200
2001 $12.30 -55.9% 400 -$4,920.0 $9,225.0 100
2002 $3.11 -74.7% 800 -$2,488.0 $4,820.5 50
2003 $4.47 43.7% -1550 $6,928.5 $6,928.5 -1550
AM 29.4%
GM -16.0%
DWR -30.7%
The DWR is slighthly higher in the first strategy because the timing of the purchases was somewhat better
CF-2 Wealth-2
-$8,560.0 $8,560.0
-$15,488.0 $46,464.0
-$5,576.0 $39,032.0
-$1,230.0 $18,450.0
-$155.5 $4,820.5
$6,928.5 $6,928.5
-32.1%
The DWR is slighthly higher in the first strategy because the timing of the purchases was somewhat better
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 3
Q1
Year Return
1994 0.9%
1995 38.4%
1996 26.3%
1997 28.4%
1998 22.4%
1999 12.6%
2000 10.2%
2001 -7.6%
2002 -8.9%
2003 20.6%
SD (T) 15.0%
Q2
Year Return
1994 13.5%
1995 42.8%
1996 39.8%
1997 59.9%
1998 15.7%
1999 63.4%
2000 -0.3%
2001 -34.5%
2002 0.2%
2003 37.7%
SD (T) 29.0%
SD (T-1) 30.5%
AMEX is riskier than Exxon but less risky than Intel
Q3
Year Return
1994 13.5%
1995 42.8%
1996 39.8%
1997 59.9%
1998 15.7%
1999 63.4%
2000 -0.3%
2001 -34.5%
2002 0.2%
2003 37.7%
AM 23.8%
R-2*SD -34.1%
R+2*SD 81.7%
The 95% confidence interval is wider than that calculated for Exxon but narrower than that calculated for Intel
Q4
Year Exxon Intel AMEX
1994 0.9% 3.4% 13.5%
1995 38.4% 78.2% 42.8%
1996 26.3% 131.3% 39.8%
1997 28.4% 7.4% 59.9%
1998 22.4% 69.0% 15.7%
1999 12.6% 39.1% 63.4%
2000 10.2% -26.9% -0.3%
2001 -7.6% 4.9% -34.5%
2002 -8.9% -50.3% 0.2%
2003 20.6% 106.6% 37.7%
GM 13.3% 23.8% 20.0%
Approx GM 13.4% 25.3% 20.5%
It works well in general, with the approximation improving for series with smaller returns (Exxon) and worsening for those with larger returns (Intel)
The 95% confidence interval is wider than that calculated for Exxon but narrower than that calculated for Intel
It works well in general, with the approximation improving for series with smaller returns (Exxon) and worsening for those with larger returns (Intel)
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 4
Q1
Year Pepsi HP
1994 -9.5% 28.1%
1995 56.7% 69.4%
1996 6.2% 21.1%
1997 36.6% 25.3%
1998 14.3% 10.7%
1999 -12.5% 67.7%
2000 42.6% -28.6%
2001 -0.5% -34.0%
2002 -12.1% -13.9%
2003 12.0% 34.5%
AM 13.4% 18.0%
SD 23.2% 33.9%
Rho 0.13
The correlation between Pepsi and HP is quite low, which is unsurprising given their very different lines of businesses
Q2
xP xHP Risk Return
100.0% 0.0% 23.2% 13.4%
90.0% 10.0% 21.5% 13.8%
80.0% 20.0% 20.5% 14.3%
70.0% 30.0% 20.2% 14.8%
60.0% 40.0% 20.6% 15.2%
50.0% 50.0% 21.7% 15.7%
40.0% 60.0% 23.4% 16.2%
30.0% 70.0% 25.6% 16.6%
20.0% 80.0% 28.1% 17.1%
10.0% 90.0% 30.9% 17.6%
0.0% 100.0% 33.9% 18.0%
Lowest risk for xP=70% and xHP=30%
MVP for xP=70.6% and xHP=29.4%
Q3
4 assets
5 assets
You get the picture by now, you can do this one yourself!
12%
13%
14%
15%
16%
17%
18%
19%
18% 23%
R
e
t
u
r
n
s

2 / 1
34 4 3 24 4 2 23 3 2 14 4 1 13 3 1 12 2 1
4
4
2
4
2
3
2
3
2
2
2
2
2
1
2
1
} 2 2 2 2 2 2 ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) {( Cov x x Cov x x Cov x x Cov x x Cov x x Cov x x SD x SD x SD x SD x SD
p

The correlation between Pepsi and HP is quite low, which is unsurprising given their very different lines of businesses
23% 28% 33% 38%
Risk
2 / 1
34 4 3 24 4 2 23 3 2 14 4 1 13 3 1 12 2 1
4
4
2
4
2
3
2
3
2
2
2
2
2
1
2
1
} 2 2 2 2 2 2 ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) {( Cov x x Cov x x Cov x x Cov x x Cov x x Cov x x SD x SD x SD x SD x SD
p

Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 5
Q1
Date NOR SPA
1994 24.1% -3.9%
1995 6.5% 31.2%
1996 29.2% 41.3%
1997 6.7% 26.2%
1998 -29.7% 50.6%
1999 32.4% 5.3%
2000 -0.4% -15.5%
2001 -11.7% -11.0%
2002 -6.7% -14.9%
2003 49.6% 59.2%
AM 10.0% 16.8%
SD 22.6% 26.9%
Rho 0.27
The correlation between Spain and Norway is rather low, particularly in the context of the highly-integrated European markets
Q2
xN xS Risk Return Ret/Risk
100.0% 0.0% 22.6% 10.0% 44.39
90.0% 10.0% 21.2% 10.7% 50.47
80.0% 20.0% 20.2% 11.4% 56.38
70.0% 30.0% 19.6% 12.1% 61.58
60.0% 40.0% 19.4% 12.7% 65.55
50.0% 50.0% 19.7% 13.4% 67.96
40.0% 60.0% 20.5% 14.1% 68.78
30.0% 70.0% 21.6% 14.8% 68.28
20.0% 80.0% 23.1% 15.5% 66.85
10.0% 90.0% 24.9% 16.1% 64.87
0.0% 100.0% 26.9% 16.8% 62.62
The MVP consists of xN=61.8% and xS=38.2%
The MVP has an expected return of 14.2% and a volatility of 19.43%
The MVP has a higher RAR (68.78) than the 100% Norwegian portfolio (44.39)
The xN=40%/xS=60% portfolio has the highest RAR (68.78 compared to 44.39 for Norway and 62.61 for Spain)
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
18%
R
e
t
u
r
n

The correlation between Spain and Norway is rather low, particularly in the context of the highly-integrated European markets
The xN=40%/xS=60% portfolio has the highest RAR (68.78 compared to 44.39 for Norway and 62.61 for Spain)
18% 20% 22% 24% 26% 28%
Risk
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 6
Q1 - Q6
R(i) 10% Stocks Var(p) SD(p)
SD(i) 30% 1 0.0900 30.00%
Var(i) 0.09 2 0.0550 23.45%
Cov(i,j) 0.02 3 0.0433 20.82%
Rho(i,j) 0.5 4 0.0375 19.36%
5 0.0340 18.44%
6 0.0317 17.80%
7 0.0300 17.32%
8 0.0288 16.96%
9 0.0278 16.67%
10 0.0270 16.43%
11 0.0264 16.24%
12 0.0258 16.07%
13 0.0254 15.93%
14 0.0250 15.81%
15 0.0247 15.71%
16 0.0244 15.61%
17 0.0241 15.53%
18 0.0239 15.46%
19 0.0237 15.39%
20 0.0235 15.33%
21 0.0233 15.28%
22 0.0232 15.23%
23 0.0230 15.18%
24 0.0229 15.14%
25 0.0228 15.10%
26 0.0227 15.06%
27 0.0226 15.03%
28 0.0225 15.00%
29 0.0224 14.97%
30 0.0223 14.94%
As the number of stocks increases risk falls at a decreasing rate
After some 20 or so stocks risk decreases are negligible
Expectedly, the variance of the 30-stock portfolio (0.0223) is very similar to the average covariance across stocks (0.02)
0%
5%
10%
15%
20%
25%
30%
35%
0 5 10 15 20 25 30 35
R
i
s
k

(
S
D
)

Stocks
Expectedly, the variance of the 30-stock portfolio (0.0223) is very similar to the average covariance across stocks (0.02)
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 7
Q1
Year BH Cisco MS S&P500
1994 25.0% 8.7% -0.8% 1.3%
1995 57.4% 112.5% 40.6% 37.6%
1996 6.2% 70.5% 43.2% 23.0%
1997 34.9% 31.4% 80.7% 33.4%
1998 52.2% 149.7% 21.6% 28.6%
1999 -19.9% 130.8% 103.1% 21.0%
2000 26.6% -28.6% 12.2% -9.1%
2001 6.5% -52.7% -28.3% -11.9%
2002 -3.8% -27.7% -27.2% -22.1%
2003 15.8% 85.0% 47.9% 28.7%
AM 20.1% 48.0% 29.3% 13.0%
Beta 0.5 2.8 1.5
There does appear to be a positive relationship between risk (beta) and return
Q2
BH Cisco MS
RRE 7.2% 19.7% 12.8%
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 8
Q1
Year Abbott RP ML RP MRP SMB HML
1994 5.1% -20.8% -4.1% 0.4% -0.1%
1995 24.9% 40.1% 31.0% -6.9% -3.5%
1996 18.2% 56.4% 16.3% -1.9% 0.2%
1997 25.7% 75.6% 26.1% -3.7% 11.1%
1998 47.2% -12.0% 19.4% -23.3% -15.0%
1999 -31.2% 20.2% 20.2% 11.7% -39.4%
2000 30.7% 60.4% -16.7% -5.7% 21.4%
2001 12.0% -27.7% -14.8% 28.4% 27.3%
2002 -30.5% -29.9% -22.9% 4.4% 3.7%
2003 15.0% 52.5% 30.7% 28.1% 15.1%
Abbott Betas 0.66 -1.03 1.05
ML - Betas 1.41 -0.42 1.00
Q2
Abbot ML
RRE-CAPM 8.5% 13.3%
RRE-3FM 9.1% 15.5%
The RRE estimates between the two models are somewhat different
However, note that if the CAPM is used, betas should be estimated from independently, in which case we would obtain:
Abbot ML
Beta 0.37 1.08
RRE-CAPM 6.7% 11.2%
Note, then, that the differences between the (properly-estimated) CAPM-RREs and 3FM-RREs widen
However, note that if the CAPM is used, betas should be estimated from independently, in which case we would obtain:
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 9
Q1 - Q2
Year China Korea
1994 -46.4% 23.7%
1995 -21.1% -3.3%
1996 37.5% -38.1%
1997 -25.3% -66.7%
1998 -42.4% 141.1%
1999 13.3% 92.4%
2000 -30.5% -49.6%
2001 -24.7% 48.7%
2002 -14.0% 8.6%
2003 87.6% 35.9%
AM -6.6% 19.3%
SSD-AM 20.9% 40.1%
SSD-Rf 30.0% 31.7%
SSD-0 26.0% 28.9%
VAR-95: -71.4% -81.0%
VAR-99: -98.6% -123.3%
According to all three SSDs the Korean market is riskier than the Chinese market
Also, according to the VaR the risk of 'extreme' losses is higher in the Korean market
Note, however, that any loss higher than -100% is not possible when investing (long) in equities
This is one of the problems of using distributions that have no lower bound (like the Normal distribution)
This is one of the problems of using distributions that have no lower bound (like the Normal distribution)
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 10
Q1 - Q4
Country AM Country Jensen Country Treynor Country
CAN 13.6% USA 4.6% USA 8.3 USA
USA 13.3% CAN 4.5% ITA 8.1 CAN
ITA 12.3% ITA 3.9% CAN 7.9 ITA
FRA 11.0% FRA 2.0% FRA 5.6 FRA
GER 10.6% UK 1.2% UK 5.2 UK
UK 9.1% GER 1.1% GER 4.7 WOR
WOR 8.7% WOR 0.0% WOR 3.7 GER
JAP 1.9% JAP -6.3% JAP -3.5 JAP
The rankings based on risk-adjusted returns do differ across the different measures
The 'best' country in which to invest depends on the investor's perception of risk (Is it beta? The SD? The SSD?)
However, in this case, the US provides the best RARs for all three measures of risk (beta, SD, and SSD)
Sharpe Country RAP Country Sortino
52.3 USA 12.8% USA 39.9
43.8 CAN 11.5% CAN 37.0
31.1 ITA 9.6% ITA 29.0
31.0 FRA 9.6% FRA 26.1
28.9 UK 9.3% GER 22.0
25.1 WOR 8.7% UK 20.2
24.5 GER 8.6% WOR 17.8
-14.8 JAP 2.8% JAP -11.9
The 'best' country in which to invest depends on the investor's perception of risk (Is it beta? The SD? The SSD?)
However, in this case, the US provides the best RARs for all three measures of risk (beta, SD, and SSD)
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 11
Q1
1a 1b 1c 1d 1e 1f
Weights Weights Weights Weights Weights Weights
-28.6% 0.0% 10.0% -33.1% -25.7% -25.1%
31.5% 14.2% 30.0% 6.1% 48.0% 50.8%
34.9% 26.4% 30.0% 91.3% -1.8% -8.1%
62.2% 59.4% 30.0% 35.7% 79.5% 82.4%
Ep Ep Ep Ep Ep Ep
27.1% 29.9% 31.1% 22.6% 30.0% 30.5%
SDp SDp SDp SDp SDp SDp
33.4% 42.4% 48.9% 29.8% 38.9% 40.0%
Sharpe R. Sharpe R. Sharpe R. Sharpe R. Sharpe R. Sharpe R.
0.66 0.59 0.53 0.59 0.64 0.64
Q2
Date Disney Microsoft 2a 2b 2c
1994 8.7% 51.6% Weights Weights Weights
1995 29.0% 43.6% 82.9% 79.3% 56.8%
1996 19.1% 88.3% 17.1% 20.7% 43.2%
1997 42.9% 56.4%
1998 -8.5% 114.6% Ep Ep Ep
1999 -1.7% 68.4% 13.9% 15.0% 22.0%
2000 -0.4% -62.8%
2001 -27.7% 52.7% SDp SDp SDp
2002 -20.3% -22.0% 21.8% 21.9% 26.0%
2003 44.4% 6.8%
AM 8.5% 39.8% Sharpe R. Sharpe R. Sharpe R.
SD 23.7% 49.8% 0.41 0.46 0.66
Rho 0.05
2d
Weights
25.4%
74.6%
Ep
31.8%
SDp
38.0%
Sharpe R.
0.71
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 12
Q1
P(R>R*) 1 5 10 15 20 25
-5% 82.73% 98.26% 99.86% 99.99% 100.00% 100.00%
0% 73.93% 92.42% 97.87% 99.35% 99.79% 99.93%
5% 63.82% 78.55% 86.83% 91.46% 94.31% 96.15%
10% 53.17% 57.06% 59.93% 62.10% 63.90% 65.46%
12% 48.94% 47.62% 46.64% 45.89% 45.26% 44.70%
14% 44.79% 38.48% 33.94% 30.60% 27.91% 25.63%
16% 40.77% 30.08% 23.02% 18.30% 14.82% 12.16%
18% 36.91% 22.74% 14.53% 9.78% 6.75% 4.74%
20% 33.24% 16.63% 8.53% 4.67% 2.63% 1.51%
25% 25.02% 6.59% 1.66% 0.45% 0.13% 0.04%
30% 18.27% 2.15% 0.21% 0.02% 0.00% 0.00%
For T=1, as the target return increases the probability of achieving higher returns than the target plausibly decreases
The same is true for T=10
For R*=10%, the probability of achieving returns higher than that is plausibly increasing in T (because R*<GM)
For R*=14%, the probability of achieving returns higher than that is plausibly decreasing in T (because R*>GM)
Q2
2a
T 1 5 10 15 20 25
Prob 4.0% 64.3% 89.8% 96.9% 99.0% 99.7%
2b
T 1 5 10 15 20 25
Wealth $1,115 $1,723 $2,969 $5,115 $8,812 $15,183
30
100.00%
99.98%
97.36%
66.84%
44.20%
23.66%
10.05%
3.36%
0.88%
0.01%
0.00%
For T=1, as the target return increases the probability of achieving higher returns than the target plausibly decreases
For R*=10%, the probability of achieving returns higher than that is plausibly increasing in T (because R*<GM)
For R*=14%, the probability of achieving returns higher than that is plausibly decreasing in T (because R*>GM)
30
99.9%
30
$26,159
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 13
Q1
1a 1b - 1c Prices 1d
Rf 4.3% No growth $14.8 Price
MRP 5.5% 3% growth $30.7
Beta 0.30 4% growth $46.9
RRE 6.0%
Q2
Price $66.9
$61.5
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 14
Q1
2003
EFCF $2,584
CFCF $2,570
Q2
CFCF
0 $2,570
1 $2,827
2 $3,110
3 $3,421
4 $3,763
5 $4,140
6 $4,471
7 $4,828
8 $5,215
9 $5,632
10 $6,082
TV $78,174
Q3
WACC 14.2%
Q4
Price $7.9
Q5
Given that Oracle is trading at $11.4 but its intrinsic value is only $7.9, it may not be wise to buy
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 15
Q1
RRE 14.28%
Price $8.0
Q2
RRUE 14.26%
Price $7.9
Q3
The FTE estimate and the APV estimate are very close to each other and to the WACC estimate calculated before
This is the way it should because, when properly applied, all three models should yield the same result
In this case, the near equality also follows from the fact that Oracle is a virtually-unlevered company
The FTE estimate and the APV estimate are very close to each other and to the WACC estimate calculated before
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 16
Q1
Growth 42.3%
Q2
Growth 71.6%
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 17
Q1
As usual, not all ratios point in the same direction, so the question cannot be answered with certainty
In addition, recall that if the multiple of company A is higher than that of company B, it would be incorrect to rush to the conclusion that B is relatively a better buy
It may well be the case that B deserves to be cheaper than A (its fundamentals are not as good as those of A)
Q2
Again, we cannot rush to a conclusion without further analysis
It may be the case that the fundamentals of Pfizer now are better than they were in the past, in which case it would be expected to be more expensive
For example, Pfizer's growth may have increased or its risk may have decreased
Q3
Again, we cannot rush to a conclusion without further analysis
It may be the case that the fundamentals of Pfizer are better than those of its peers, in which case it would be expected to be more expensive
For example, Pfizer may be expected to grow faster than its peers, or it may be expected to be less risky than its peers
Q4
Pfizer still looks expensive relative to its peers
Still, the same caveats mentioned above apply
Even after adjusting by growth, if Pfizer is perceived as less risky than its peers, then it would be expected to be more expensive
In addition, recall that if the multiple of company A is higher than that of company B, it would be incorrect to rush to the conclusion that B is relatively a better buy
It may well be the case that B deserves to be cheaper than A (its fundamentals are not as good as those of A)
It may be the case that the fundamentals of Pfizer now are better than they were in the past, in which case it would be expected to be more expensive
It may be the case that the fundamentals of Pfizer are better than those of its peers, in which case it would be expected to be more expensive
For example, Pfizer may be expected to grow faster than its peers, or it may be expected to be less risky than its peers
Even after adjusting by growth, if Pfizer is perceived as less risky than its peers, then it would be expected to be more expensive
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 18
Q1
US 5.75% BH Motorola Delta
Price (1a) $1,092.5 $959.0 $1,080.9 $1,044.5
Price (1b) $987.6 $864.7 $982.4 $950.8
As expected, when the discount rates increase, bond prices decrease
Note that we're actually calculating our estimates of intrinsic value rather than prices (which are the numbers given in the table)
Q2
US 5.75% BH Motorola Delta
SAy 1.8% 2.1% 2.2% 7.6%
Ay 3.6% 4.2% 4.5% 15.1%
EAy 3.7% 4.2% 4.5% 15.7%
The Ay and the EAy are different because the latter (but not the former) takes into account the effect of compounding
It is the EAy that properly captures the return delivered by a bond
Note that we're actually calculating our estimates of intrinsic value rather than prices (which are the numbers given in the table)
The Ay and the EAy are different because the latter (but not the former) takes into account the effect of compounding
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 19
Q1
US 5.75% BH Motorola Delta
Price (1a) $1,092.5 $959.0 $1,080.9 $1,044.5
Price (1b) $987.6 $864.7 $982.4 $950.8
Price (1c) $1,211.0 $1,065.4 $1,191.7 $1,149.8
Q2
US 5.75% BH Motorola Delta
Change 1-2 -9.6% -9.8% -9.1% -9.0%
Change 1-3 10.8% 11.1% 10.3% 10.1%
Their sensitivity to changes in interest rates is similar though the BH bond seems to have slightly higher interest-rate risk
Q3
Interest-rate risk and default risk are not necessarily correlated in theory, and they are not in this case
For example, Delta has much higher credit risk and yet it does not have higher interest-rate risk
Their sensitivity to changes in interest rates is similar though the BH bond seems to have slightly higher interest-rate risk
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 20
Q1
US 5.75% BH Motorola Delta
Price (1a) $1,092.5 $959.0 $1,080.9 $1,044.5
Price (1b) $1,038.5 $910.4 $1,030.2 $996.2
Price (1c) $1,150.0 $1,010.6 $1,134.6 $1,095.6
Q2
US 5.75% BH Motorola Delta
Duration 5.2 5.3 5.0 4.9
In all cases the durations are longer than the average maturity of 3.5 years because the bonds' cash flows are heavily weighted towards the end of their life
Q3
US 5.75% BH Motorola Delta
Mod Dur 5.0 5.1 4.7 4.6
These numbers indicate the expected change in the bonds' prices when discount rates increase by 1 percentage point
Q4
US 5.75% BH Motorola Delta
Change 1-2 -4.9% -5.1% -4.7% -4.6%
Change 1-3 5.3% 5.4% 5.0% 4.9%
Average 5.1% 5.2% 4.8% 4.8%
For each bond, the average change (in absolute value) is virtually identical to the bond's modified duration
This indicates that the modified duration is a very good approximation to the interest-rate risk of these bonds
In all cases the durations are longer than the average maturity of 3.5 years because the bonds' cash flows are heavily weighted towards the end of their life
These numbers indicate the expected change in the bonds' prices when discount rates increase by 1 percentage point
For each bond, the average change (in absolute value) is virtually identical to the bond's modified duration
This indicates that the modified duration is a very good approximation to the interest-rate risk of these bonds
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 21
Q1
A B C D E E'
0 -100 -100 -100 100 -10 -90
1 30 100 75 -15 4 26.0
2 30 100 75 -15 4 26.0
3 30 100 75 -15 3 27.0
4 30 75 75 -15 3 27.0
5 30 -300 -250 -15 3 27.0
NPV $13.7 $13.6 -$17.5 $43.1 $3.1 $10.6
IRR 15.2% 5.3% N/A -8.9% 22.4% 14.5%
IRR-2 72.3%
Q2
Yes, because its NPV is positive (and its IRR is higher than the discount rate)
Q3
Yes, because its NPV is positive
This is the case although one of the two IRRs is lower than the discount rate
When the NPV and the IRR approaches conflict, the NPV gives the more correct answer
Q4
No, because its NPV is negative
Note that this project has no IRR
Q5
The company should go for project A because it has a higher NPV
This is the case despite the fact that A has a lower IRR than E
As "project" E' shows, the NPV of the incremental cash flows of A has a positive NPV ($10.6)
Q6
No, because the project's NPV is negative (-$0.5m)
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 22
Q1
Time CFs - Low CFs - High E(CFs)
0 -200 -200 -200
1 20 40 30
2 20 40 30
3 20 40 30
4 20 40 30
5 20 40 30
6 20 40 30
7 20 40 30
8 20 40 30
9 20 40 30
10 20 40 30
NPV ($77.1) $45.8 ($15.7)
According to the project's expected CFs, the company should not buy the rights to extract copper
That being the case, this is obviously not a good project in the case of low CFs
However, when CFs are high, the project does deliver a positive NPV
Q2
Time CFs - Low CFs - High
0
1 -200 -200
2 20 40
3 20 40
4 20 40
5 20 40
6 20 40
7 20 40
8 20 40
9 20 40
10 20 40
NPV-1 ($84.8) $30.4
NPV-0 $13.8
RO $29.5
As before, if CFs are low, the company should not invest in this project
And also as before, if the CFs are high, the company should invest in this project
The NPV of the project, evaluated one period down, the road is $30.4m
With 50% probability the company will invest and obtain this NPV, and with 50% probability the company will not invest
The weighted-average of this two scenarios, today, is a positive $13.8m
Therefore, it pays for the company to invest $5m in the rights to extract copper
The implicit value of the real option is $29.5m (the difference between $13.8m and -$15.7m)
With 50% probability the company will invest and obtain this NPV, and with 50% probability the company will not invest
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 23
Q1 - Q4
Industry ROC COC Capital NOPAT RI RI-2
Cable TV 6.7% 10.3% $189.0 $12.6 ($6.9) ($6.9)
Drugs 28.6% 10.2% $174.1 $49.8 $32.0 $32.0
Life Ins 51.3% 8.4% $126.7 $65.1 $54.4 $54.4
Property Ins 0.3% 8.4% $115.6 $0.3 ($9.4) ($9.4)
Tel Equip 4.6% 14.2% $39.8 $1.8 ($3.8) ($3.8)
According to this framework, the drug and life insurance industries created value and the other three destroyed value in 2003
According to this framework, the drug and life insurance industries created value and the other three destroyed value in 2003
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 24
Q1
Call price = $3.9
Q2
Put price = $2.3
Q3
$50.0 $40.0 $50.0 $40.0 25.0% 15.0%
Call $7.6 $1.5 $1.9 $7.2 $4.7 $3.2
Put $0.9 $4.9 $5.0 $0.7 $3.0 $1.6
Q4
The qualitative relationships discussed in the text do hold in the exhibit above
S X SD
1.00 0.5 6.0% 4.0%
$4.7 $3.1 $4.1 $3.8
$2.5 $2.0 $2.1 $2.4
Rf T
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 25
Q1 - Q2
Beta = 0.8 Beta = 0.8 Beta = 1.2 Beta = 1.2
S $10,000 $10,000 $10,000 $10,000
c 5.0% 5.0% 5.0% 5.0%
y 1.0% 1.0% 1.0% 1.0%
T 0.5 0.5 0.5 0.5
F(0) $10,202 $10,202 $10,202 $10,202
Dow(0) 10000 10000 10000 10000
Dow(1) 9000 11000 9000 11000
Rm -9.5% 10.5% -9.5% 10.5%
Beta 0.8 0.8 1.2 1.2
Pfolio (0) $4,000,000 $4,000,000 $4,000,000 $4,000,000
Rp -7.1% 8.9% -11.9% 12.1%
Pfolio (1) $3,716,000 $4,356,000 $3,524,000 $4,484,000
Gain/Loss -$284,000 $356,000 -$476,000 $484,000
F(0) $10,202.0 $10,202.0 $10,202.0 $10,202.0
F(1) 9000 11000 9000 11000
N 32 32 48 48
Gain/Loss $384,644.3 -$255,355.7 $576,966.4 -$383,033.6
Total G/L $100,644.3 $100,644.3 $100,966.4 $100,966.4
Invest @Rf $4,101,260.5 $4,101,260.5 $4,101,260.5 $4,101,260.5
Gain $101,260.5 $101,260.5 $101,260.5 $101,260.5
Difference -$616.2 -$616.2 -$294.0 -$294.0
In both cases the hedges are almost perfect
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 26
Q1
1a - For both European and Americans it is the same buying the flat-screen TV in the US or in Europe
1b - In this case the flat-screen TV is cheaper in Europe, and therefore this is not an absolute PPP equilibrium
1c - In this case the flat-screen TV is cheaper in the US, and therefore this is not an absolute PPP equilibrium
Q2
2a- The dollar will depreciate to 1.544
2b- US interest rates will rise to 9% and European interest rates will rise to 6%
2c- The dollar-euro one-year forward exchange rate will be 1.542
2d- At a forward rate of 1.542 Americans would be indifferent between investing in the US or in Europe
2e- At a forward rate of 1.542 Europeans would be indifferent between investing in the US or in Europe
2f- Borrow 100, convert to dollars and invest in the US at 9% for one year, locking a certain profit of 4.5
2g- Borrow $100, convert to euros and invest in Europe at 6% for one year, locking a certain profit of 2.5
1b - In this case the flat-screen TV is cheaper in Europe, and therefore this is not an absolute PPP equilibrium
1c - In this case the flat-screen TV is cheaper in the US, and therefore this is not an absolute PPP equilibrium
2d- At a forward rate of 1.542 Americans would be indifferent between investing in the US or in Europe
2e- At a forward rate of 1.542 Europeans would be indifferent between investing in the US or in Europe
2f- Borrow 100, convert to dollars and invest in the US at 9% for one year, locking a certain profit of 4.5
2g- Borrow $100, convert to euros and invest in Europe at 6% for one year, locking a certain profit of 2.5
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 27
Q1 - Q2
Year ARG BRA
1993
1994 -23.6% 65.7%
1995 12.9% -19.2%
1996 20.3% 42.5%
1997 24.6% 27.3%
1998 -24.3% -39.6%
1999 34.3% 67.2%
2000 -25.1% -11.4%
2001 -18.3% -17.0%
2002 -50.5% -30.7%
2003 101.3% 115.0%
Mean 5.2% 20.0%
Median -2.7% 8.0%
Mode N/A N/A
Var (T) 0.1703 0.2392
SD (T) 41.3% 48.9%
Covar 0.1577
Correl 0.78
Var (T-1) 18.9% 26.6%
SD (T-1) 43.5% 51.6%
The mean and the median are different because these distributions are skewed (asymmetric)
The mode does not exist because there is no value that occurs more often than others (all values occur just once in both samples)
The covariance indicates a positive linear relationship between the stock markets of Argentina and Brazil
The correlation indicates that this positive linear relationship is quite strong
The mode does not exist because there is no value that occurs more often than others (all values occur just once in both samples)
The covariance indicates a positive linear relationship between the stock markets of Argentina and Brazil
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 28
Q1
Range AbsFreq RelFreq
(1, 2) 0 0.0%
(2, 3) 1 5.0%
(3, 4) 2 10.0%
(4, 5) 2 10.0%
(5, 6) 5 25.0%
(6, 7) 2 10.0%
(7, 8) 2 10.0%
(8, 9) 2 10.0%
(9, 10) 1 5.0%
(10, 11) 1 5.0%
(11, 12) 1 5.0%
(12, 13) 1 5.0%
(13, ) 0 0.0%
20 1
The distributions of returns does not appear to be normal, it actually appears to have a long right tail (positive skewness)
Q2 - Q3
Prob (R12%) = 50.0%
Prob (R5%) = 36.3%
Prob (R30%) = 18.4%
Prob (5%R20%) = 29.2%
0
1
2
3
4
5
6
A
b
s
o
l
u
t
e

F
r
e
q
u
e
n
c
y

The distributions of returns does not appear to be normal, it actually appears to have a long right tail (positive skewness)
0%
5%
10%
15%
20%
25%
30%
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y

Range
Range
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 29
Q1
Skewness 1.05 Sum Stats
Kurtosis 1.01 Mean 6.9%
Std Error 0.0066
Median 5.9%
Mode 5.6%
SD 3.0%
Sample Var 0.0009
Kurtosis 1.01
Skewness 1.05
Range 11.8%
Minimum 2.9%
Maximum 14.7%
Sum 138.5%
Count 20
Q2
Prob (R10%) = 55.8%
Prob (R20%) = 24.4%
Prob (5%R25%) = 38.8%
Finance in a Nutshell
Javier Estrada
FT Prentice Hall, 2005
Answer Key to Challenge Sections
Chapter 30
Q1
Regression Statistics
R Square 0.05
Adj R2 0.02
Std Error 0.01
Observations 30
ANOVA df SS MS F Signif F
Regression 1 0.0001 0.0001 1.60 0.22
Residual 28 0.0012 0.0000
Total 29 0.0012
Coefficients Std Errors t Stat P-value
Intercept 0.001 0.005 0.25 0.80
X Variable 1 0.060 0.048 1.26 0.22
The R square is rather low at 5%, indicating that volatility (SD) explains about 5% of the variability in MRs
Consistently, the slope coefficient is not significant according to the standard t-test (and, say, a 5% significance level)
The slope coefficient indicates that a 1% increase in SD leads to a 0.6% increase in MRs
In short, SDs do not seem to be very closely related to MRs
Q2
Regression Statistics
R Square 0.11
Adj R2 0.08
Std Error 0.01
Observations 30
ANOVA df SS MS F Signif F
Regression 1 0.0001 0.0001 3.45 0.07
Residual 28 0.0011 0.0000
Total 29 0.0012
Coefficients Std Errors t Stat P-value
Intercept 0.003 0.002 1.38 0.18
X Variable 1 0.004 0.002 1.86 0.07
The R square is still rather low but over twice as high compared to that of the previous regression
Beta is not significant at the usual 5% level of significance (but it would be at the 10% level)
Beta seems to explain MRs somewhat better than volatility but neither provides a substantial explanation for the variability in MRs
Q3
Regression Statistics
R Square 0.11
Adj R2 0.05
Std Error 0.01
Observations 30
ANOVA df SS MS F Signif F
Regression 2 0.0001 0.0001 1.69 0.20
Residual 27 0.0011 0.0000
Total 29 0.0012
Coefficients Std Errors t Stat P-value
Intercept 0.004 0.005 0.80 0.43
X Variable 1 -0.016 0.074 -0.21 0.84
X Variable 2 0.004 0.003 1.32 0.20
The R square of this regression is almost identical to that of the previuos regression
Neither volatility nor beta seem to explain a substantial part of the variability in MRs
The adjusted R squares of this regression and the previous one indicate that it does not pay to add volatility to a regression between MRs and betas
The R square is rather low at 5%, indicating that volatility (SD) explains about 5% of the variability in MRs
Consistently, the slope coefficient is not significant according to the standard t-test (and, say, a 5% significance level)
Beta seems to explain MRs somewhat better than volatility but neither provides a substantial explanation for the variability in MRs
The adjusted R squares of this regression and the previous one indicate that it does not pay to add volatility to a regression between MRs and betas