Question 1

Talkie is a company that has a patent right for a new mobile technology that is expected to enable it to generate growth of 20% for the next three years. From the beginning of year 4, the company expects to grow at a constant rate of 5%. The company just paid a dividend of $2.20 on 31 Dec of Year 0.

(a) Compute the estimate of the current price of Talkie shares. Assume the required return on equity is 10%.

The realized return of Talkie shares and Stock M for the past 5 years are detailed below:

(b) Compute the arithmetic mean and standard deviation of returns over the past 5 years for each stock?

Question 2

Suppose Jack, president of Heart Limited has hired you to advise on the firm’s cost of capital.

(a) Based on the most recent financial statements, Heart’s total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Jack, therefore, reasons, “We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million = 12.5%.” Appraise Jack’s statement.

(b) The company paid $1 million in dividends in the past year. Its market capitalization was $10 million. Based on his own analysis, Jack suggests that the company increases its use of equity financing, because “debt costs 12.5 percent, but equity only costs 10 percent; thus, equity is cheaper.” Appraise Jack’s statement.

“Heart Limited has one bond in issue expiring in eight years, paying 0 coupons, and has a face value of $1000. It is currently traded at $720, Beta =1.2, risk-free rate is 2%, and historic market risk premium is 5.5%. Assume the ratio of debt to equity is 2:1, and the corporate tax rate is 20%.”

(c) Determine the WACC for Heart Limited.

Question 3

Suppose you observe the following situation:

(a) According to the above information, could we figure out the market return and risk-free rate? Explain your answer.

(b) Discuss the possibility of including zero beta or negative beta assets in your portfolio. Explain the pros and cons of including these types of assets.

Question 4

The Ting Hai effect is a Hong Kong stock market phenomenon in which there is a sudden and unexplained drop in the stock market.

The effect is named after Ting Hai, the main character in the drama The Greed of Man, who was portrayed by Adam Cheng. Initially, the Ting Hai effect occurred whenever the drama or its sequel was broadcast in Hong Kong.

However, it was observed later that the phenomenon also takes place whenever a new film or a television series starring Adam Cheng is released. In the two decades since 1992, nearly every time Cheng has appeared in a movie or television show – which has been more than 30 times – the Hang Seng Index declined.

(a) Assume that some investors did take advantage of the Ting Hai effect and made an abnormal profit from it. Judge whether any form of market efficiency is violated in the Hong Kong stock market. Explain your reasoning.

(b) You are a financial advisor, and your client Alice is an Adam Cheng fan. A new film about Adam will be released in 2 weeks’ time, and Alice is asking whether she should sell all her positions now. How should you respond?

Question 5

Your client Ben is in his late 30s (married, with two kids) and working as a full-time doctor in ZZ hospital. He deposited all this money in the bank, but the interest rate is decreasing all the time. He heard that the return on stock investment is much higher.

As he knows one medicine company very well, he plans to open a stock account and invest all his money in that company first. Subsequently, as he gets to know other medicine companies, he planned to diversify his portfolio into those companies. Appraise Ben’s investment plan.