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Problem Set (160 points)

 

Directions:  Answer the following problems IN DETAIL. Your analysis must be typed and should be free of grammatical errors and “slang” terms.” Wherever appropriate, make sure you supplement your discussion with graphical analysis and equations.  The graphs may be hand drawn, but please make sure they are neat.  There are no restrictions or requirements on working in groups.  The one exception is that each person must hand in his/her OWN work.  In economic terms, there are no input restrictions; however, the output MUST be yours.

 

1. (25 points) The focus of this problem is on the monthly rates of return on the stocks of five companies and the monthly rates of return on the S&P 500. The stocks and their ticker symbols are Apple (AAPL, communication devices), Alphabet (GOOGL, internet), Amgen (AMGN), biotechnology)), J.P. Morgan Chase (JPM, banking), and Exxon Mobil (XOM, energy). The returns run from January of 2012 through February of 2017, 62 months. Please do five things. For each of the companies, fill in the table below by (1) estimating the single-index model and checking the R-squared, alpha, and beta for statistical significance by using the F and t values, respectively; (2), computing the total risk, (3) determining an expected return for each company (a simple average will suffice); (4) calculating the expected return to beta; and (5) ranking the return-to-beta results from the highest value to the lowest value. Which of these stocks would you buy? Why?

 

                                                                                    Total     Average        Return to

Symbol           R2     F    Alpha     t   Beta      t        Risk      Return          Beta

AAPL

AMGN

GOOGL

JPM

XOM

 

The data file is in an Excel file on Blackboard labeled Data S17 Problem Set 1. The stocks are listed by their respective ticker symbols and the S&P 500 is listed as “SP 500.”

 

If you use Excel, you need to do the following:  (1) from the menu bar, open “Tools,” followed by “Data Analysis;” and (2) invoke the “Regression” options. Note that the X-range refers to the independent variable (e.g., returns on the S&P 500) and the Y-range refers to the dependent variable (e.g., returns on Apple).

 

2. (25 points) Please compare two U.S. restaurants, McDonald’s (MCD) and Wendy’s, as follows:

 

(1) an analysis of the financial position of each firm by using the twelve criteria discussed in class;

(2) a graphical analysis and explanation of the cost and revenue structure of each firm as discussed in class (e.g., revenue and cost curves)

(3) an analysis of the expected “return and risk” of each firm (i.e., do the same analysis of each company that you did in problem 1)

4. On the basis of your analysis, which company would you invest in? Why?

 

You will find the rates of return for each company in the file for the first problem. Also listed on Blackboard are the Value Line summaries for each company.

 

3. (15 points) The operative question among macro policy specialists and investors is “by how much will the Federal Reserve target higher interest rates in 2017?” Currently, the U.S. economy is operating at 80% of full capacity, with fourth quarter GDP growth registering at 2.0%. The unemployment rate is at 4.7%, which is effectively close to full employment according to the Federal Reserve System.  What do you think the central bank will do? Why? How does the drop in commodity prices, such as oil, coal, copper, and natural gas, affect your response? Please use the “money line-spending line” diagram and aggregate demand and supply curves as part of your analysis.  

 

4.  (10 points) After considerable negotiation with its owners, you have purchased a home for $550,000. After a 20 percent down payment, you finance the remainder under a twenty-year mortgage at the annual percentage rate (APR) of 3.75%).

 

a. (4 points) What are your monthly payments? Show ALL your work, including your use of the formula.

 

b. (6 points) Over time, what is the total cost of the home?  After the second monthly payment, what is the total amount that you owe each in interest and principal? Show ALL your work, including your use of the formulas.  (Note:  In the intermediate steps of your calculations, take the decimal point to four places.  At the final calculation, round off to two places.)

 

5. (5 points) Practically speaking, why bother with a zero-coupon bond – a fixed-income security that does not explicitly pay interest – when you can receive periodic interest payments from a coupon bond?

 

6. (5 points) Demonstrate that you understand the difference among coupon yield, current yield, and yield to maturity with the following illustration for Morgan Stanley debt, par value of $1000: current price of $1022, coupon rate of 4.4%, issue date of September 15, 2010, settlement date of October 10, 2010, and maturity date of June 1, 2017. To solve for the yield to maturity, please use the yield formula (i.e., “Yield Example”) provided on Blackboard.

 

7. (5 points) What is the maximum price that you would pay up for a series of A-rated

debentures (i.e., corporate bonds) each with a face value of $1000, that promise to pay 31 more semi-annual coupons of $19.25 each at a yield to maturity of 3.12%? Please show how you arrive at your result. (This is a test to see if you understand the inverse relationship between interest rates and bond prices.)

 

8. (10 points) You are provided with the following monthly expected returns, each of which is represented by E(Ri), and betas for the following stocks. Please estimate the capital asset pricing model and draw conclusions about the significance and realism of the results.  (Note: Please use conventional tests of the R-squared and coefficients.) On the basis of your results, please name at least three of the stocks that you would recommend as “buys.”

 

                  E(Ri)          Beta

AA

0.8

1.3

AXP

0.8

1

BA

1

0.80

C

0.8

1.35

CAT

1.2

1.7

CSCO

0.6

0.95

KO

0.4

0.6

DIS

0.6

0.95

DD

0.6

0.7

ED

0.4

0.55

XOM

0.4

0.6

GE

0.5

0.9

GM

0.6

0.8

HPQ

0.4

1.3

HD

0.4

0.9

HON

0.9

1.15

INTC

0.8

1.1

IBM

0.9

1.4

IP

0.4

0.80

JNJ

0.3

0.35

MCD

0.6

0.5

MSFT

0.8

1.2

MMM

0.5

0.9

JPM

0.9

1.70

PG

0.4

0.45

SYK

0.6

0.4

T

0.6

1

UTX

1.1

1.1

WMT

1

0.8

WPC

0.7

1.2

 

 

 

Symbols: Alcoa (AA), American Express (AXP), AT&T (T), Boeing (BA), Citigroup (C), Caterpillar (CAT), Coca Cola (KO), Consolidated Edison (ED). Disney (DIS), Dupont (DD), Eastman Kodak (EK), Exxon Mobil (XOM), General Electric (GE), General Motors (GM), Hewlett-Packard (HPQ), Home Depot (HD), Honeywell (HON), Intel (INTC), International Business Machines (IBM), International Paper (IP), Johnson and Johnson (JNJ), McDonalds (MCD), Microsoft (MSFT), 3M (MMM), J.P. Morgan Chase (JPM), Procter and Gamble (PG), Stryker (SYK), United Technologies (UTX), Wal-Mart (WMT), and W.P. Cary (WPC)

 

9. (20 points) 

 

a. (15 points) According to the CFO of Kansas City Southern (KSU), the railroad spent $175 million in 2009 to rebuild an abandoned rail line in order to provide the railroad with ready access to growing markets in Mexico (where U.S. auto manufactures have been building news plants). The railroad predicts a free cash flow of $26 million per year from the project. From the standpoint of net present value, do you think this is a good investment? To begin, the company’s WACC was 8.13% from 2009 through 2016. You will need its WACC from 2017 onward. To guide your analysis, please see the railroad’s Value Line summary page on Blackboard under “KSU 2017,” which includes KSU’s (financial) capital structure and estimated beta. The company’s bond rating is “BBB,” as assessed by Standard & Poor’s Corporation, with an interest rate of 5.1%. For ease of estimation, assume a corporate tax rate of 35%. Please show all your work. (Hint: To estimate the WACC, you will need the cost of equity from the estimates of the capital asset pricing model in problem 8. Because the KSU data are annual but the CAPM data are monthly, you will have to annualize the CAPM estimates before estimating KSU’s cost of equity.)

 

b. (5 points) In what year does the internal rate of return exceed the WACC? What do you conclude by comparing the internal rate of return to a less formal means of estimating the cost of capital, such as the current interest rate on the bonds plus three percentage points? What do you conclude about the profitability of the project now? Please show your work.

 

10. (10 points) In the world of stock selections, it is common to find statements such as “Alphabet gets an upgrade and a ‘buy’ recommendation from Piper Jaffray, with a target price of $1,000” and “Amazon is upgraded from a ‘hold’ to a ‘buy’ at Goldman Sachs.” In terms of the rapidity and breadth with which financial markets incorporate new information, should any of us believe these recommendations are valuable; that is, will investments in these stocks lead to superior gains? Please be precise and thorough. (Note: this is not an opinion question, but one that has a definite answer.)

 

11. (30 points)

 

a. (25 points) You are 26 years of age (very young and very wise). Your birthday is in June. Using a series of monthly contributions, you are determined to build an investment portfolio that will enable you to reach an inflation-adjusted, after-tax sum of at least $1.5 million by the time you reach the ripe young age of 65. Please assume the present tax structure remains in place for the length of your investment horizon and that the long-run inflation factor is approximated by the 20-year increase in the Consumer Price Index, from February of 1997 through February of 2017, or from 159.6 to 243.6 (as obtained from the U.S. Department of Labor). However, in being moderately risk-averse, you are not willing to take unnecessary risks (e.g., portfolios dominated by large-beta stocks, speculating with options, selling short, etc.), and you prefer a buy-and-hold strategy, as opposed to one based on frequent trading. To get started, assume that you begin with $10,000 — accumulated since recently employed — and will choose from the securities listed below, eight of which are individual stocks, with their respective expected twelve-month returns and betas. Which ones will you choose? Why? As part of your analysis, assume you will make your first payment in June of 2017 and your last payment when you turn 65.

 

As part of your estimates, and to make sure the security returns in your portfolio are not strongly positively correlated with each other, you will have to compute the correlation between each pair of security returns. The data from which to do so are posted on Blackboard. They run from January of 2011 through March of 2016, 63 data points per security. Please be sure to show ALL your work and describe how you have arrived at the results. For the foreseeable future, if the maximum amount that you can save per month is $1,000.00, how likely is it that you will reach your goal?  Please explain and show how you have arrived at your conclusion.

 

                                                            Expected

Stock                                                  Annual Return                      Beta

Apple (AAPL)                                                11%                                         1.00

Alphabet (GOOGL)                            10%                                         1.00

Amgen (AMGN)                                13%                                         1.20

Exxon Mobil   (XOM)                                    6%                                           0.90

Johnson & Johnson (JNJ)                  8%                                           0.60

J.P. Morgan (JPM)                             11%                                         1.60

McDonald’s (MCD)                           5%                                           0.50

3M  (MMM)                                       9%                                           1.10

20-year “Aaa” corporate bonds           4.0%                                        0.20

Three-month U.S. Treasury bills         0.20%                                      0

Ten-year Treasury note                       2.50%                                      0

S&P 500 (Vanguard 500 VFINX)     9%                                           1

 

b. (5 points) If the price of one of the stocks you have selected rises faster than you had expected, but you still want to hold the stock for the long term, how will you hedge your risk?  Please be thorough and specific.

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