Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Gome Drug Products Ltd. (GDPL) is faced with several possible investment projects. For each, the total cash outflows required will occur in the initial period. The cash outflows, expected net present values and standard deviations are as follows:


All projects have been discounted at a risk-free rate of 8% and it is assumed that the distribution of their possible net present values are normal.

Required:
a) construct a risk profile for each of these projects in terms of the profitability index.

b) Ignoring size problems, do you find some projects clearly dominated others? Should size problem be ignored?

c) What is the probability that each of the projects will have a net present value ≥0

ANSWER
(a) Fundamental distinction between a futures contract and an option on a futures contract in a manner that futures and options modify portfolio risk.

Futures                                        Options
– An obligation/contract                          – A right or option
– Standardized                                           – Flexible
– Effected only on the maturity date      – Can be exercised before expiry
– Requires margins to be deposited with      – Does not required margins a clearing house

Risk modification futures hedge against all risks fixing the price in advance while option hedge against the downsize risks.

(b) To hedge against interest rates we can forward contracts options or swaps.

i) To protect against upward movement in interest rates and accompanying downward price movements the company should buy a put option.


iii) Maendeleo would not exercise its put option as it is out of the money. The company would be cut the 15,000 premium paid for the option.

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