University of Cape Town

Quantitative Finance Selected

Topics (BUS4087S)
Test 1: 26 August 2013
Time allowed: 1
1
2
hours plus 10 minutes reading time Total marks: 50
Instructions:
Approved calculators may be used, but all memories and user-supplied programs must
be cleared before you begin the examination.
You have ten minutes at the start of the test to read the questions. You are strongly advised
to use this time for reading only, but notes may be made on the test question paper (not in
your answer booklet). You then have ninety minutes to complete the paper.
You must not start writing your answers in the booklet until instructed to do so.
Answer each of sections A and B in a separate answer booklet, and ensure that your details
are lled out on each answer booklet you hand in.
BUS4087S Test 1, 2013 2
Section A
1. Your company is considering investing in one of two machines, both of which have
an expected lifetime of 5 years; however, you plan to replace whichever machine you
purchase after 3 years to avoid maintenance problems towards the end of its lifespan.
In both cases, you will depreciate the investments on a straight-line basis over 5 years
to a residual value of 25% of purchase price.
The costs and projected revenue associated with each machine are set out below:
Machine A Machine B
Purchase price 800,000 1,200,000
Working capital required 350,000 450,000
Annual revenue generated 450,000 650,000
Annual operating expenses 100,000 180,000
Sale price after 3 years 500,000 750,000
(i) Evaluate, at a risk discount rate of 10% per annum eective, which of the two
machines the company should purchase given that the company is taxed at a rate
of 40% of earnings. [5]
(ii) State with reason whether you think a decrease in the corporate tax rate would
reinforce the above decision, or make the less preferred option relatively more
attractive. [1]
Total: [6]
2. You are a venture capitalist considering an investment of R250 million in a new business,
for which your NPV calculations in the absence of exibility reveal a value of only R200
million. A prototype product will be launched and over the next year, you estimate
that the value of the venture will either increase by 100% or reduce by 50%. In each of
the following two years, depending on the extent to which market demand for the nal
product is established and the impact of competitive pressure, the underlying asset will
either increase by 40% or decline by 30%, with equal probability. The investors have
three embedded options which can be exercised at the end of any of the rst three years:
an option to scale back operations to a capacity which will reduce the underlying value
by 50% but also deliver an immediate saving of R40 million, or to expand operations
(and the value of the asset) by 80% at an immediate cost of R200 million, or to abandon
operations at any stage for a salvage value of R60 million.
Using a three-period binomial model, where each period is a year, assuming a con-
tinuously compounded risk-free interest rate of 2% per annum, calculate the value of
the project including the expansion, contraction and abandonment options, and hence
decide whether or not the rm should proceed with the investment. [11]
3. Name and describe three common approaches to dividend policy, highlighting their
relative merits and drawbacks. [5]
Section total: [22]
BUS4087S Test 1, 2013 3
Section B
4. Shleifer developed a model of inecient markets which included a group of noise
traders. Name the two biases displayed by this group, and explain how these lead to
systematic impacts on price adjustment. [4]
5. An argument is often mounted by proponents of ecient markets that any irrationality
on the part of individual market participants will create arbitrage opportunities for
informed traders, whose protable trades will drive the noise traders out of the mar-
ket, thus maintaining an equilibrium consistent with economic rationality. Outline the
behavioural response to this argument, making reference to the so-called twin pillars of
behavioural nance. [5]
6. An investor with current wealth of R2 million must make a choice between investing
all of her wealth over the next year in a risk-free asset yielding 5% or in a risky asset
yielding the following possible returns:
Return Probability
-15% 10%
-5% 20%
5% 30%
20% 30%
30% 10%
(i) Determine which of the options would be preferred if the investors risk preferences
were characterised by each of the following, where w is measured in millions of
Rands:
(a) Logarithmic utility: U(w) = ln w [2]
(b) Power utility with coecient = 2: U(w) =
w
1
1
[2]
(c) Negative exponential utility with coecient = 3: U(w) = 1 e
w
[2]
(d) Cumulative prospect theory (CPT) preferences with a reference point equal
to current wealth, a value function exponent of 0.9 for both losses and gains, a
loss aversion coecient of 1.6, and probability weighting given by the following
functions:
w
+
(p) =
p
0.8
(p
0.8
+ (1 p)
0.8
)
1
0.8
, w

(p) =
p
0.9
(p
0.9
+ (1 p)
0.9
)
1
0.9
[10]
(ii) By considering the coecients of relative risk aversion, comment on whether the
relative results for the power and negative exponential functions are in line with
your expectations. [3]
Total: [19]
Section total: [28]
END OF PAPER
BUS4087S Test 1, 2013 4
Solutions
Section A
1. Annual cashow = (R C D)(1 t) +D
Terminal cashow = S
M
+W t(S
M
S
A
)
Calculations:
Machine A Machine B Dierence
Initial outlay 1,150,000 1,650,000 500,000
Annual cashow 258,000 354,000 96,000
Terminal cashow 826,000 1,164,000 338,000
NPV(A) = 112,194
NPV(B) = 104,876
(or NPV(A-B) = 7,318)
Therefore choose Machine A .
2. Note that the tree is recombining after the rst period.
Without exibility:
[3 marks for correct values]
q
1
=
e
0.02
0.5
2 0.5
= 0.346801
q
2
=
e
0.02
0.7
1.4 0.7
= 0.45743
Letting V denote the value at each terminal node without exibility, the value V
f
with
exibility is dened as follows:
BUS4087S Test 1, 2013 5
V
f
= max (V, 1.5V 80, 0.5V + 20, 30)
For earlier nodes, we ignore the expansion option (as this is an American call) and
further compare with the option value:
e
0.03

qV
u
f
+ (1 q)V
d
f

Resulting values:
Therefore invest.
[8 marks for formulae, values and conclusion]
3. Residual dividend approach: retain earnings for positive NPV projects, return the
rest to shareholders.
Stable dividend policy: base dividends on sustainable long-run earnings expectations.

Target payout ratio: pay out a specied proportion of earnings as dividends.

The residual dividend approach has the relative advantage of allowing protable in-
vestment opportunities to be pursued without concern about dividends , which is
a drawback for the other two , and allowing shareholders to maximise their return
on capital . The stable dividend policy allows for the greatest stability in dividend
payments from year to year , although the target payout ratio will result in stable
dividends if earnings are stable and the residual dividend approach can be rendered
more stable by taking a longer-term view of capital needs . The target payout ratio
ensures that dividends are linked to protability .
Max 5
BUS4087S Test 1, 2013 6
Section B
4. Shleifers noise traders display:
conservatism , i.e. an over-reliance on anchors and adjustment which is slower
than a rational Bayesian. This leads to initial underreaction to news ch.
the representativeness heuristic , which leads to a tendency for traders to see
patterns in random sequences , and leads to systematic overreaction ch.
5. The twin pillars of behavioural nance are the well-known aspects of cognitive psychol-
ogy and the less-known limits of arbitrage .
The latter pillar argues that the opportunities for rational traders to exploit arbitrage
opportunities are limited by:
market constraints, e.g. on short sales
avoidance of the riskiest markets
most importantly, the fact that arbitrageurs funds are limited and usually
third-party funds
Arbitrageurs thus have limited funds and limited time to exploit opportunities . Ap-
parent mispricings may persist longer than the aribtrageurs capital can sustain ex-
posure , and investors may demand money back before anomalies are corrected ,
forcing positions to be closed out at a loss . The fear of such early withdrawal may
make arbitrageurs reluctant to fully exploit apparent arbitrage opportunities.
6. (i) (a) U(risky) = 0.1 ln(1.7) + 0.2 ln(1.9) + 0.3 ln(2.1) + 0.3 ln(2.4) + 0.1 ln(2.6) =
0.76221
U(risk-free) = ln(2.1) = 0.74194
So log investor prefers risky asset.
(b) U(risky) =
0.1(1.7)
1
+ 0.2(1.9)
1
+ 0.3(2.1)
1
+ 0.3(2.4)
1
+ 0.1(2.6)
1
1
=
0.47041
U(risk-free) = (2.1)
1
= 0.47619
So power investor prefers risky asset.
(c) U(risky) = 0.1(1 e
5.1
) + 0.2(1 e
5.7
) + 0.3(1 e
6.3
) + 0.3(1 e
7.2
) +
0.1(1 e
7.8
) = 0.99791
U(risk-free) = 1 e
6.3
= 0.99816
So negative exponential investor prefers risk-free asset.
(d) Three positive and two negative possibilities, so m = 2, n = 3.

+
n
= w
+
(p
n
),

m
= w

(p
m
),

+
i
= w
+
(p
i
. . . p
n
) w
+
(p
i+1
. . . p
n
), 0 i n 1,

i
= w

(p
m
. . . p
i
) w

(p
m
. . . p
i1
), m i < 0.
BUS4087S Test 1, 2013 7
w
+
(p) =
p
0.8
(p
0.8
+ (1 p)
0.8
)
1
0.8
, w

(p) =
p
0.9
(p
0.9
+ (1 p)
0.9
)
1
0.9
V (f) =
n

i=m

i
v(x
i
)
v(w) =

w
0.9
if x 0
1.6(w)
0.9
if x < 0

For our investor:
w

(0.1) =
0.1
0.9
(0.1
0.9
+ 0.9
0.9
)
1
0.9
= 0.121116
w

(0.3) =
0.3
0.9
(0.3
0.9
+ 0.7
0.9
)
1
0.9
= 0.315911
w
+
(0.7) =
0.7
0.8
(0.7
0.8
+ 0.3
0.8
)
1
0.8
= 0.642089
w
+
(0.4) =
0.4
0.8
(0.4
0.8
+ 0.6
0.8
)
1
0.8
= 0.405645
w
+
(0.1) =
0.1
0.8
(0.1
0.8
+ 0.9
0.8
)
1
0.8
= 0.144344

2
= w

(0.1) = 0.121116

1
= w

(0.3) w

(0.1) = 0.315911 0.121116 = 0.194795

1
= w
+
(0.7) w
+
(0.4) = 0.642089 0.405645 = 0.237164

2
= w
+
(0.4) w
+
(0.1) = 0.405645 0.144344 = 0.261301

3
= w
+
(0.1) = 0.144344
v
2
= v(0.3) = 0.541414
v
1
= v(0.1) = 0.201428
v
1
= v(0.1) = 0.125893
v
2
= v(0.2) = 0.438383
v
3
= v(0.3) = 0.631446
CPT value of risky asset:
V (f) =
2

i=2

i
v
i
= 0.130742
CPT value of risk-free asset: v(0.1) = 0.125893
Prospect theory investor prefers risky asset.
(ii) Power coecient of relative risk aversion is = 2.
For the negative exponential:
U

(w) = e
w

(w) =
2
e
w

BUS4087S Test 1, 2013 8

R(w) =
wu

(w)
u

(w)
= w
(Or note that negative exponential has constant absolute risk aversion with coef-
cient , so hence has relative risk aversion coecient = w).
At current wealth of 2, coecient of RRA = 6. Range of future wealth is [1.7,
2.6] which implies a range of RRA of [5.1, 7.8]. Clearly the negative exponential
investor is considerably more risk-averse than the power investor, and it is therefore
not surprising that she chooses the risk-free asset when the power investor chooses
the risky asset.