Assume that it is the middle of 2010. Charlotte Lynch has been working for a year as an analyst for an investment company that specialises in serving very wealthy clients. These clients often purchase shares in closely-held investment funds (i.e., those with very limited numbers of shareholders). In late 2008 the market for certain types of securities based on real-estate loans simply collapsed as the sub-prime mortgage scandal unfolded. Charlotte’s firm saw this market collapse as an opportunity to put together a fund to purchase some of the mortgage-backed securities shunned by investors, acquiring them at bargain prices and holding them until either the underlying mortgages are repaid or the market for these securities recovers.
The investment company began putting together sales information concerning the possible returns of the new fund and made the following predictions over the ensuing year as a function of the performance of the economy:
|State of the economy||Probability||Fund return|
Charlotte’s boss has asked her to perform a preliminary analysis of the new fund’s performance potential for the coming year. In addition to the information provided above, Charlotte observes that the risk-free rate of interest for the following year is 4.5%, the market risk premium is 5.5% and the beta for the new investment is 3.55.
Assume that you are in Charlotte’s role, and address each of the following:
- What are the expected rate of return and standard deviation for the new fund?
- What is the reward-to-risk ratio for the fund based on use of the fund’s standard deviation as a measure of risk?
- What is the required rate of return for the fund based on the Capital Asset Pricing Model (CAPM)?
- Based on your analysis, do you think the proposed fund offers a fair return given its risk? Explain.
You would like to have $50,000 in 15 years. To accumulate this amount, you plan to deposit an equal sum in the bank each year. Your deposits will earn 7% interest compounded annually. Your first payment will be made at the end of the year.
- How much must you deposit annually to accumulate your target amount?
- If you decide to make a large lump-sum deposit today instead of the annual deposits, how large should this lump-sum deposit be? (Assume you can earn the same 7% annual interest on this deposit.)
- At the end of five years, you will receive $10,000 and will deposit this in the bank to meet your goal of accumulating $50,000 at the end of 15 years. In addition to this deposit, how much must you deposit in equal annual deposits to reach your goal? (Again, assume you can earn 7% annual interest on this and your other deposits.)
The rate of return for an Australian Commonwealth Government Treasury Bond is given as 5% per annum. The yearly return for the Australian share market is given as 12% per annum. Suppose a listed company has a beta value of 1.2.
- Calculate the investors’ required rate of return for the company’s shares.
- If the expected rate of return for the company’s shares was 15% per annum, would you buy shares in the company? Explain your answer.
- Explain why Australian Commonwealth Government Treasury Bonds are considered to be a risk-free investment.
An investor wishes to invest $10,000 in a term deposit with a bank for a term of 2 years. The bank is offering term deposits with an interest rates of 3% per annum with annual compounding, 2.95% per annum with half-yearly compounding, and 2.9% per annum with monthly compounding.
- Which term deposit provides the best investment?
- Calculate the future value (FV) of the best investment.
- If the marginal income tax rate for the investor is 45%, what is the total amount of interest received after tax for the best investment?
- Explain what is meant by the market capitalisation of a listed company. How would you find the market capitalisation of a listed company?
- If a company has 10,000,000 ordinary shares on issue with a current market price of $1.50 per share, calculate the market capitalisation of the company.
- The financial goal of a listed company is to maximise shareholders’ wealth, by maximising the company’s share price. Is this the same as maximising the company’s profit? Explain your answer.
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