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BANGLADESH UNIVERSITY OF PROFESSIONALS

Subject: Financial Management
Subiect code: FIN 7302
MBA (Professional)

Term PaPer on

lntermediate Problem Solution on Chapter 8, 9 & 11

Submitted To

Professor Mohammad Sogir Hossain Khandkor' Phd

Submitted BY
Uttam Kumar Ghosh
MBA (Professional)
Roll No. 190200'10
Date of submission: September 02, 2020
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BANGLADESH UNIVERSITY OF PROFESSIONALS
Subject: Financial Management
Subject code: FIN 7302
MBA (Professional)

Submitted To

Professor Mohammad Sogir Hossain Khandkor, Phd

Submitted By
Uttam Kumar Ghosh
MBA (Professional)
Roll No. 19020010
Date of submission: September 02, 2020
 Chapter 8: Risk and Rates of Return
1. The probability distribution of a less risky expected return is more peaked than that of a
riskier return. What shape would the probability distribution be for (a) completely certain
returns and (b) completely uncertain returns?
Answer: In finance, Probability distribution is used to evaluate the risk on an investment.

(a) Completely certain returns: The shape of the probability distribution of an asset that supplies
investors with completely certain returns would be a vertical line. Assuming that returns are
represented by the x axis and frequency of occurrence by the y axis. This composition would
suggest that returns would not fluctuate or they are fully certain. Result straight vertical line with
rate of return as x-intercept.

(b) Completely uncertain returns: the shape of the probability distribution of an asset that
supplies investors with completely uncertain returns would be a horizontal line. Where returns
are represented by the x axis and frequency of occurrence by the y axis. This shape would
indicate that the variability of the returns is infinite and there is fully uncertainty of returns.
Result straight horizontal line along the x-axis.

2. (a) If investors’ aversion to risk increased, would the risk premium on a high-beta stock
increase by more or less than that on a low-beta stock? Explain.
Answer: If investors’ aversion to risk increased then the risk premium on high-beta stock
increase more than that on a low-beta stock. It is because the effect of the change in the risk
aversion is stronger on more risky securities than in less riskier securities. Beside this, there is
the positive relationship between risk aversion and the risk premium. If the risk aversion
increases then the risk premium also goes up causing the slope of the security market line (SML)
to become steeper. The steeper the Security market lines higher the required rate of return. Risk
premium for stock x can be calculated as: Risk premium of market (RPM) multiply by beta of
stock x (βx). For example,
Market risk premium (RPM) = 6%
Beta for stock X = 0.7
Beta for stock Y = 1.4
Now, calculation of risk premium for stock X and Y
Risk premium for stock X = Market risk premium × beta
= 6% × 0.7
= 4.2%

Risk premium for stock Y = Market risk premium × beta

= 6% × 1.4
= 8.4%
Again, let’s suppose investors’ risk aversion increase that leads market risk premium to increase
from 6% to 8% and beta for those stock remain the same.
Risk premium for stock X = Market risk premium × beta
= 8% × 0.7
= 5.6%
Risk premium for stock Y = Market risk premium × beta
= 8% × 1.4
= 11.2%

The above example clearly shows that risk premium for stock Y which has higher beta increase
more than stock X which has lower beta. Therefore, risk premium on a high-beta stock increase
more than low beta stock when investors’ aversion to risk increase.

(b) If a company’s beta were to double, would its required return also double?
Answer: No, expected return would not be doubled if company’s beta were to double.
According to Security Market Line (SML) equation, Company’s expect return is Risk free return
plus market risk premium (market risk – risk free return) times Company’s beta.
For example, Risk free return = 8%
Market risk premium = 2%
Current beta of company (β) = 0.4
Then Company’s expected return = rRF + (rm – rRF) β
= 8% + (2% × 0.4 )
= 8.8%
Now support Company’s beta (β) doubled from 0.4 to 0.8
Then Company’s expected return = rRF + (rm – rRF) β
= 8% + (2% × 0.8)
= 9.6%
Therefore, expected return of the Company increase when beta of the company increase but it
would not be double if Company’s beta double.
3. ECRI Corporation is a holding company with four main subsidiaries. The percentage
of its capital invested in each of the subsidiaries (and their respective betas) are as follows:

Subsidiary Percentage of Capital Beta

Electric utility 60% 0.70
Cable company 25 0.90
Real estate development 10 1.30
International/special 5 1.50
projects
a. What is the holding company’s beta?
b. If the risk-free rate is 6% and the market risk premium is 5%, what is the holding company’s
required rate of return?
c. ECRI is considering a change in its strategic focus; it will reduce its reliance on the electric
utility subsidiary, so the percentage of its capital in this subsidiary will be reduced to 50%. At the
same time, it will increase its reliance on the international/special projects division, so the
percentage of its capital in that subsidiary will rise to 15%. What will the company’s required
rate of return be after these changes?

Answer: Here Given, Krf = 0.06, (Km-Kf) = 0.05

a. We Know the portfolio beta, Bp = w1b1+w2b2+---------------+ wnbn
= (0.6×0.7)+(0.25×0.90)+(0.1×1.30)+(0.05×1.50)
= 0.85 (Answer)
b. We know rate of Return is, Kj = Krf + Bp (Km-Krf)
= 0.06 + 0.85×0.05
= 0.1025
= 10.25% (Answer)

c. After Change the Portfolio beta is, Bp = (0.5×0.7)+(0.25×0.90)+(0.1×1.30)+(0.15×1.5)

= 0.93
So, after change company’s rate of return, Kj = Krf + Bp (Km – Krf)
= 0.06 + 0.93× 0.05
= 0.1065
= 10.65% (Answer)
 Chapter 9: Stock Valuation
1.
(a) Why does the value of a share of stock depend on dividends?
(b) A substantial percentage of the companies listed on the NYSE and the NASDAQ don’t
pay dividends, but investors are nonetheless willing to buy shares in them. How is this
possible given your answer to the previous question?
(c) Referring to the previous questions, under what circumstances might a company choose
not to pay dividends?
Answer:
(a) Dividend payments are the primary method companies share their profits with
stockholders. Numerous investors rely on dividends for their living expenses and
construct a stock portfolio primarily to maximize their dividend income. Dividend
payments increase demand for a stock and consequently result in a higher stock price.
Dividend payments also send a strong message to the investor community and boost the
confidence of potential buyers.

(b) If a company has got great investment opportunities ahead for them, then the company
can choose to invest the surplus cash in these investments and chose to withhold paying
dividends. In such a case, the investors may still chose to buy the stock in expectation of
capital gains through appreciation of share price.

(c) There may be three circumstances under which a company not to pay dividends:

Reinvesting Profits: The first reason why some companies do not pay dividends is
because they would rather reinvest those profits back into the business. This is exactly
what growth stage companies do, but some companies never stop!
Acquisitions: Another reason why companies will hold off on dividend payments and
hoard cash is for acquisitions. This happens when one company essentially purchases
another one, and they merge under one entity.

Financial Trouble: Here’s a different scenario to consider. Sometimes you will run into a
company that used to pay a dividend, but no longer does. Or, they slash the dividend. The
main reason behind this is financial hardship.
 2. Fletcher Company’s current stock price is $36.00, its last dividend was $2.40, and its
required rate of return is 12%. If dividends are expected to grow at a constant rate, g, in
the future and if rs is expected to remain at 12%, what is Fletcher’s expected stock price 5
years from now?
Solution:
Here Given, Po = $30, Do = $2.40 Kj =12%, P5 =?
We Know, Po = Do (1+g)/(Kj-g)

Or, 36 = 2.40 (1+g) /0.12-g

Or, 4.32-36g = 2.40 + 2.40g

Or, g = 1.92 /38.4

Or, g = 0.05 = 5%

Now we again know, P5 = Po (1+g) 5

= 36 (1+0.05)5

= $ 45.95

Therefore, the firm’s expected stock price 5 years from now, P5 is $45.95. (Ans.)
 Chapter 11: Capital Budgeting
1. If a project with conventional cash flows has a payback period less than the project’s life, can
you definitively state the algebraic sign of the NPV? Why or why not? If you know that the
discounted payback period is less than the project’s life, what can you say about the NPV?
Explain.

Answer: For conventional cash flows, a payback period less than the project’s life means that
the NPV is positive for a zero discount rate, but nothing more definitive can be said. NPV may
be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or
greater than the IRR. If a project’s discounted payback period is less than the project’s life, it
must be the case that NPV is positive.

2. Suppose a project has conventional cash flows and a positive NPV. What do you know about
its payback? Its discounted payback? Its profitability index? Its IRR? Explain.

Answer: Assuming conventional cash flows, if a project has a positive NPV for a certain
discount rate, then it will also have a positive NPV for a zero discount rate; thus, the payback
period must be less than the project life. Since discounted payback is calculated at the same
discount rate as is NPV, if NPV is positive, the discounted payback period must be less than the
project’s life. If NPV is positive, then the present value of future cash inflows is greater than the
initial investment cost; thus, PI must be greater than 1. If NPV is positive for a certain discount
rate R, then it will be zero for some larger discount rate R*; thus, the IRR must be greater than
the required return.

3. You are evaluating Project A and Project B. Project A has a short period of future cash flows,
while Project B has relatively long future cash flows. Which project will be more sensitive to
changes in the required return? Why?

Answer: Due to time value of money, Project B’s NPV would be more sensitive to changes as it
has relatively long future cash flows. Cash flows that occur further out in the future are always
more sensitive to changes in the interest rate. This sensitivity is similar to the interest rate risk of
a bond.