1. Explain why the Ricardian Equivalence Theorem is unlikely to hold in an economy that experiences net immigration flows.

2. Demonstrate, with the aid of a diagram, how the Ricardian Equivalence Theorem will not hold for an economy where individuals are debt-constrained.

 

 

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1.Fernando Baltra Company wished to issue zero coupon straight debt with approximately a 15-year maturity. The company is rated single A by both Moody’s and S&P. How would you estimate the approximate yield if the October 1999 yield curve in Fig.1 and the spreads in Fig.2 prevailed? What is the approximate yield the company would pay?

1. 2) Consider a 1-year risky zero coupon bond issued by company A. Suppose that the proba- bility of default (risk neutral) of A in 1-year is 0.5% and the recovery rate of the bond is 40%. Given riskless 1-year interest rate being 3% (continuously compounding), calculate the 1-year credit spread for company A.

2. 3) Consider a 3-month European put option with a strike price of $100 on an underlying asset which has a current price of $90 and annualized volatility of 20%. The market interest rate is assumed to have a flat term structure so that the interest rate is a fixed quantity of 8%.

   (a) Determine the option value by Black Scholes formula.

   (b) What is the meaning of delta-normal approach to VAR for measuring risks of deriva- tives positions?

   (c) What is the 99% daily delta-normal VaR in return of issuing this option? (Hint:z0.01=2.33)

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Part B: Homework Assignment (Please submit on or before the due date)1. Fernando Baltra Company wished to issue zero coupon straight debt with approximatelya 15-year maturity. The company is rated single A by both Moody’s and S&P. Howwould you estimate the approximate yield if the October 1999 yield curve in Fig.1 andthe spreads in Fig.2 prevailed? What is the approximate yield the company would pay?2. Consider a 1-year risky zero coupon bond issued by company A. Suppose that the proba-bility of default (risk neutral) of A in 1-year is 0.5% and the recovery rate of the bond is40%. Given riskless 1-year interest rate being 3% (continuously compounding), calculatethe 1-year credit spread for company A.3. Consider a 3-month European put option with a strike price of $100 on an underlyingasset which has a current price of $90 and annualized volatility of 20%. The marketinterest rate is assumed to have a ?at term structure so that the interest rate is a ?xedquantity of 8%.(a) Determine the option value by Black Scholes formula.(b) Whatisthemeaningofdelta-normalapproachtoVARformeasuringrisksofderiva-tives positions?(c) What is the 99% daily delta-normal VaR in return of issuing this option? (Hint:z =

 

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1.  Figure II.4 shows an affine transformation acting on an F.(a) Is this a linear transformation? Why or why not? (b) Express this affine transformation in the form x → Mx + u by explicitly giving M and u.

2.  Prove the angle sum formulas for sin and cos:

 

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1. Find cost of capital for a company of your choice.

Steps involved: Determine equity beta, determine its current capital structure, determine its pre-tax cost of debt (keep in mind that determining cost of debt for companies with low credit rating involves different approach than for companies with high debt rating), determine weighted average cost of capital (r WACC)

2. Propose an expansion project for the company from question 1 in a business area that is different from its current area(s). Find asset return in the proposed area of business. Find weighted average cost of capital of the expansion project assuming that the company would finance it with the same mixture of debt and equity as the rest of the company.

3. You have just been hired by Internal Business Machines Corporation (IBM) in their capital budgeting division. Your first assignment is to determine the free cash flows and NPV of a proposed new type of tablet computer similar in size to an iPad but with the operating power of a high-end desktop system. Development of the new system will initially require an initial capital expenditure equal to 10% of IBM’s Property, Plant, and Equipment (PPE) at the end of fiscal year 2014. The project will require an additional investment equal to 10% of the initial investment after the first year of the project, a 5% increase after the second year, and a 1% increase after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the product are expected to be 3% of IBM’s total revenue for the fiscal year 2014. The new product’s revenues are expected to grow at 15% for the second year then 10% for the third and 5% annually for the final two years of the expected life of the project. Your job is to determine the rest of the cash flows associated with this project. Your boss has indicated that the operating costs and net working capital requirements are similar to the rest of the company and that depreciation is straight-line for capital budgeting purposes. Here are some tips to guide your analysis:

1. Obtain IBM’s financial statements. (If you really worked for IBM you would already have this data, but at least you won’t get fired if your analysis is off target.) Down load the annual income statements, balance sheets, and cash flow statements for the last fiscal years from Yahoo! Finance (finance.yahoo.com). Enter IBM’s ticker symbol and then go to “financials.”

2. You are now ready to estimate the Free Cash Flow for the new product. Compute the Free Cash Flow for each year as

Free Cash Flow=(Revenues-Costs-Depreciation) x(1-TC) + Depreciation – Capital Expenditure –

Set up the timeline and computation of free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive.

a. Assume that the project’s profitability will be similar to IBM’s existing projects in 2014 and estimate (revenues-costs) each year by using the 2014 EBITDA/Sales profit margin. Calculate EBITDA as EBIT + Depreciation expense from the cash flow statement.

b. Determine the annual depreciation by assuming IBM depreciates these assets by straight-line method over a 5-year life.

c. Determine IBM’s tax rate by using the income tax rate in 2014.

d. Calculate the net working capital required each year by assuming that the level of Net working capital will be a constant percentage of the project’s sales. Use IBM’s 2014 net working capital/sales to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. other components of current assets and liabilities are harder to interpret and not necessarily reflective of the project’s required net working capital- for example, IBM’s cash holdings.)

e. To determine the free cash flow, deduct the additional investment and the change in net working capital each year.

3. Use Excel to determine the NPV of the project with a 12% cost of capital.

 

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