DXX

Financial Markets
PGP/ABM/FPM I, Slot II, Mid-term Examination
Date: 13th September, 2012

Name: ________________________
Section: _____

Instructions
This is an open-book exam but only course textbook Brealey-Myers is allowed. No
other written material is allowed. Laptops, smart phones and tablets are also not
allowed.
Please show your workings clearly. This will help you avail partial credits.
If necessary, you may also attach extra sheets.
Maximum Time: 2 hours

Indian Institute of Management, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Question 1. When Marilyn Monroe died on August 5, 1962 (Sunday), ex-husband Joe
DiMaggio vowed to place fresh flowers on her grave every Sunday starting August 12, 1962
for as long as he lived. A bunch of fresh flowers that the former baseball player thought
appropriate for the star cost about $5 when she died in 1962. If Joe expects to live for
another 30 years (i.e. expects to drop flowers for 30 years starting August 12), what is the
present value of this commitment given that the annual interest rate, compounded weekly,
is 10.4%, and the annual rate of inflation, compounded weekly, is 3.9%. Assuming that each
year has exactly 52 weeks, and ignoring uncertainty around Joes life expectancy, what is
the present value of this commitment?
[10]

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Question 2. Your niece is about to enter college and is confused about her career choices.
She has two options open to her. Her first option is to study biochemsitry. If she does this,
her degree would cost her 100, 000 a year for five years. Having obtained this, she plans to
get two years of practical experience. In her first year she expects to earn 5 lacs from her
job, and in the second year 6 lacs. She then plans to get her post-graduate, which will cost
her 25, 000 a year for two years. After that she will be fully qualified and can hope to earn 18
lacs per year for next 25 years. Her other alternative is to study psychology. If she does this,
she would pay 40, 000 a year for four years and then she can expect to earn 12 lacs per year
for next 30 years. You may assume the effort involved in the two careers is pretty much the
same, and for now she is only interested in the earnings the two careers provide. Assuming
all earnings and costs are paid at the end of the year and interest rates are constant: [15]
a) What advice would you give her if the going bank interest rate is 8%?
b) A day later she comes back and says she took your advice, but in fact, the interest rate
was 9%. Has your niece made the right choice?
You may assume you are advising her as if she is starting college now.

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Question 3. The firm XYZ Inc. expects today to earn 4 per share for each of the future
operating periods (beginning at time 1) if it makes no new investments and returns all
earnings as dividends to the shareholders. However, you as a newly hired WIMWI graduate
have discovered an opportunity but that requires the firm to retain (and invest) 25% of its
earnings beginning the end of year 3. This opportunity to invest will continue for each period
indefinitely. You expect the firm to earn 40% (per year) on this new investment, the return
beginning one year after each investment is made. The firms equity discount rate is 14%
throughout.
[20]
a) What is the price per share (now at time 0) of the XYZ stock if the company management
doesnt listen to you and decides not to take up the new opportunity?
b) What if the management does listen to you and decides to go ahead with the investment
- what would the price per share be now (at time 0)?
c) What part of the price in part b) is attributable to growth opportunities that you identified?
d) What is the expected price at the end of one year if the proposed investment is made?
What if the proposed investment is not made?
e) What is the dividend yield today (at time 0) if the new investment is made? What if the
new investment is not made?

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

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Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Question 4. Lio refinery has decided to suspend its dividends for the next two years. It
plans to resume its annual cash dividends of Rs. 2 a share three years from now. That is,
no dividends at the end of next two years, and dividends resume only at the end of third
year from now. It plans to offer the same dividends at the end of fourth year too, and after
that it plans to maintain an annual growth rate of 6% per year forever. Assuming that
the required rate of return from Lio is 16%, what is the fair price of a Lio share given the
Dividend Discount Model.
[5]

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Financial Markets (2012)

IIM, Ahmedabad

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Mid-term Exam

Financial Markets (2012)

IIM, Ahmedabad

Question 5. Consider a stock market which only consists of two securities. The amount of
shares and the price of each security are as follows:
[25]
Security/Data
Quantity
Price

Security A
1000
100

Security B
500
180

The prospects (expected price) of the two stocks under different market conditions with
attendant probabilities are as follows:
Expected Price of Securities under Different Market Conditions
Market Condition
State 1: Very Good
State 2: Good
State 3: Bad
State 4: Very Bad

Probability
0.10
0.40
0.40
0.10

Security A
125
120
115
110

Security B
225
207
216
198

a) What are the expected return and standard deviation of each security?
b) What are the covariances and correlations between the stocks A and B?
c) What are the expected return and standard deviation of the market portfolio?
d) If the bank rate of interest is given to be Rf , write the equation for the Capital Market
Line.
e) Do either of the two securities lie above the Capital Market Line? Why?
f) Is there any combination of the two securities that dominate the market portfolio? Why?

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Question 6. You are hired by Gold Sacks India, a major mutual fund player in the market.
As part of your first assignment your boss has asked you to provide your view on two
competing mutual funds and she has given you the following information:
[20]

Beta ()
Standard Deviation ()

Fund-X
0.8
20%

Fund-Y
1.2
32%

Assuming CAPM holds and that you can borrow and lend at the bank rate (5%), and the
expected market risk premium (expected return from the market in excess of the bank rate)
is 8%:
a) Which of the two mutual funds would you recommend to your boss if you can construct
portfolios using either of the two funds and also borrow from/lend to the bank at 5%?
b) Continuing with part a) of the question above, what is the lowest risk portfolio that gives
you an expected return of 14.6%? What is its standard deviation?
c) Now suppose that bank charges you 2% more when you have to borrow compared to
when you deposit money. Assuming that the deposit rate is unchanged at 5%, does your
answer to part b) above change? How and why?

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Question 7. Stock of a company that you hold is expected to have a price of Rs. 100 a year
from now. Assuming CAPM holds and the company is not expected to pay any dividends
during the year, how much would you be willing to sell it for today if the risk free rate is
7%, expected return from the market is 15% and its beta () is 1.5?
[5]

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