SOBEY SCHOOL OF BUSINESS MASTER OF FINANCE (MFIN) RESEARCH METHODS & SPECIAL TOPICS (MFIN6690) FINAL EXAMINATION – July 05, 2021 DUE DATE: 8.00PM, JULY 05, 2021 (Atlantic Standard Time) PLEASE READ CAREFULLY: This is an open book exam. You are allowed to consult course-related materials, including your laptop computer. Please make sure that you sub- mit the exam to the designated DROPBOX in Brightspace by 8.00PM on July 05, 2021 (Atlantic Standard Time). Please submit your answer in either MS Word or PDF file. You can also submit your Excel file as an appendix and to support your answer. The first page of your submission must contain your name and student number. Be as precise as you can in your submission; submit only the most important aspects of your model. Please write your name and student number before you start writing the exam. GOOD LUCK. NAME: _ _ _ _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ _ STUDENT NUMBER: _ _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ _ _ _ _ _ _ Questions Marks Obtained Questions 1 5 _ _ _ 2 5 _ _ _ 3 5 _ _ _ 4 5 _ _ _ 5 5 _ _ _ 6 15 _ _ _ 7 15 _ _ _ 8 15 _ _ _ Total 70 _ _ _1. Unemployment, Inflation, and the Bank of Canada The Bank of Canada is expected announce its next monetary policy report on July 14, 2021. In the last meeting, the Bank decided to keep the key target interest rate on hold at 0.25%. The rate has been on hold at its rock-bottom level since the onset of the pandemic last year and the central bank has said it won’t increase the rate until the economy has recovered. Recent data indicates that inflation has been picking up more than 3.4% while the unemployment rate remaining at an elevated level. If you are one of the Board of Governors of the Bank of Canada, what would be three KEY OBJECTIVES you would suggest the Bank of Canada to pursue while conducting monetary policy? Given the recent inflation and unemployment numbers, what would be your advice to the Bank on July 14, 2021, i.e., keep the rate on hold at 0.25%, or increase the rate to more than 0.25%, or lower the rate below 0.25%? How does the Bank of Canada make sure that the interest rate remains at the target level? Please explain your answer GRAPHICALLY and as succinctly as you can. (5 Marks)2. Gold vs Bitcoin vs USD vs VIX The following figure shows the value of $100 investment in January 1, 2015 in Gold, Bitcoin, U.S. dollar, and VIX over 6 years (2015–2020). Despite the heterogeneity in return of these assets, Central Banks of the world seem to favor Gold over other assets and are building their gold reserve at a pace that we have not seen since Richard Nixon’s, former U.S. president, abandonment of the gold standard for the U.S. dollar. Moreover, more and more investors and financial institutions are accepting Bitcoin as a legitimate financial asset and a store of value. Furthermore, volatility in the financial market seems to gone up compared to historical levels. 12 It is not obvious since all these variables are standardized with mean 0 and variance 1. However, looking at the range (Max-Min), VIX appears to be most volatile, and Gold appears to be least volatile. Q(e): 5 Marks Value of your investment from 2015- Mid-2021: It is clear from the figure that investing in Bitcoin will give you the highest possible payoff from the investment. However, students may argue that investing in Bitcoin comes with greater risk and, therefore, may have to be done with caution. In light of these observations about Gold, Bitcoin, and VIX, what do think the future holds for U.S. dollars? Do you think U.S. dollar will still be the dominant currency of reserve and preferred hedge for uncertainty and inflation in the near future? Please articulate youranswer as succinctly as you can. (5 Marks) 3. Cash vs Cashless Economy The following figure (from the International Monetary Fund (IMF)) shows that countries like Japan like to have cash as the preferred medium of transaction while countries like Sweden and Norway are planning to go cashless. Give three reasons why Japan prefers to have more cash than Sweden. Is cashless economy necessarily good or bad? (5 Marks)4. A Simple Forecasting Model Consider the following model of revenue: REV it = S 0 × K α it−1 × L β it−1 ×A 1−α−β it−1 Where REV it is the revenue (in millions of dollars) of firm i in period t , K it−1 is the capita expenditure of the firm in period t −1 , L it−1 is the labour input of the firm in period t −1 , and A it−1 is the advertising expenditure of the firm in period t − 1 . We know that the most popular empirical model in Finance is Ordinary Least Square (OLS) which is also known as the Best Linear Unbiased Estimator (BLUE). Suggest how can yo estimate the revenue model using OLS? How would you interpret the α and β coefficients from the OLS model? You observe the following data regarding the key parameters and inputs of the model based on historical data: © Sobey School of Business 3 © Saint Mary's University M.M. Rahaman MFIN6690 Parameter Min Max Average S 0 120 200 170 K 150 250 200 L 165 215 185 A 160 190 175 α 0.25 0.75 0.50 β 0.25 0.75 0.50 Based on the observed data in the table above, what would be your forecast of revenue for your firm in the next period? Be as precise as you can. (5 Marks)

5. Testing the CAPM model The following is the well-known Capital Asset Pricing Model (CAPM): R i = R f +β.(R m −R f ) where R i is the return on individual asset i , R f is the risk free rate of return, R m is the return on the market portfolio, and (R m −R f ) is the market excess return over the risk-free asset. Suppose you want to test the CAPM model using the IBM stock return. You ob- serve the following in the capital market: (i) over the last 15 years IBM stock generated, on average, 6.5% excess return over the risk-free asset (R IBM −R f ) ; (ii) over the same last 15 years, the average market excess return over the risk-free asset (R m −R f ) has been 4.5%; (iii) the variance of (R m −R f ) is 15%; (iv) the covariance between (R IBM −R f ) and (R m −R f ) is 21.6%. Based on this information, how can test and conclude whether CAPM is indeed a good asset pricing model? (5 Marks) 6. Developing the COVID-19 Vaccine The pharmaceutical industry deals with a very high degree of uncertainty. Over 90% of all products under development fail to come to the market resulting in large loses. Products that do come to the market can earn multi-billion dollar profits annually for 10-15 years until the patent for the drug expires. In this exercise, you will analyze the COVID-19 vaccine development decision by Pfizer Inc. The new vaccine being developed is called COVAX and before going to the market COVAX must go through the following stages of development:1. Initial Research & Development (R&D) Phase 2. Phase I – Pre-Clinical Testing 3. Phase II – Clinical Trial 4. Phase III – Clinical TrialOnly after all development stages succeed can the COVAX be sold to the general pop- ulation. If the COVAX fails at any stage, then the development process is terminated all together. A success at any stage leads to the next stage. You have to determine the risk-adjusted Net Present Value (NPV) from this COVID-19 vaccine development project and investigate the key drivers of the new vaccine’s profitability. You have to use the Triangular random variable from @RISK/Excel to model the following uncertain inputs at each stages of the development process: Cost, Probability of Success, and the Time Required to Complete the Stage. You will also model the PROFIT earned from the sale of COVAX as a Triangular random variable. The discount rate for this project is 15%. The input values are given below (note that the cost and profits are all-in cost/profit in millions of dollars): R&D Stage Phase I Phase II Phase III Cost: Best 50.000 10.00 350.00 3500.00 Worst 120.00 30.00 600.00 6000.00 Most Likely 70.000 15.00 480.00 4200.00 Time: Best 3.00 0.50 3.00 3.00 Worst 7.00 3.00 6.00 6.00 Most Likely 4.00 1.00 4.00 4.00 Probability of Success: Best 0.42 0.60 0.60 0.96 Worst 0.20 0.30 0.40 0.70 Most Likely 0.35 0.50 0.50 0.90 Likely Profits Once Developed Best 60000 Worst 14000 Most Likely 18000 For example, in “Phase I: Pre-Clinical Testing” will cost $10 million in the best case, $30 million in the worst case, and $15 million in the most likely case. In the best case, the Pre-Clinical stage will last for 0.50 years; in the worst case, the Pre-Clinical stage will last for 3.0 years; and in the most-likely case, the Pre-Clinical stage will last for 1.0 years. Finally, in the best case, the Pre-Clinical stage will have a success probability of 60%; in the worst case, the Pre-Clinical stage will have a success probability of 30%; and in the most-likely case, the Pre-Clinical stage will have a success probability of 50%. We are assuming here that these random variables are independent of one another.Based on these uncertain inputs, develop an NPV model for this COVID-19 vaccine de- velopment project. Report the mean, median, 5 th , 25 th , 50 th , 75 th , and 95 th percentiles of your NPV. Report the NPV empirical distribution and the Value-at-Risk charts after 5000 simulation. Which stage of the development process is the most critical input of your NPV model? Report the Tornedo graph of your sensitivity analysis. Please submit a PDF hard-copy of your excel model and you may wish to submit your excel model as an appendix. (15 Marks) 7. Mergers and Acquisition Valuation Suppose you company is considering purchasing a firm called “Cleanco”. The management of Cleanco is asking for $20 million for the acquisition. You expect the cash-flow from Cleanco to be highly uncertain. In particular, cash-flow depends on many uncertain pa- rameters such as Sales growth, Gross margin, SGA expenses, Variations in working capital, Litigation liability, and Terminal value of Cleanco. The current data provided to you by the Cleanco management is as follows:• Annual sales revenue: $40 million. • Annual cost of good sold: $28 million. • SG&A annual costs: $10 million. • Working capital: $4 million. • Tax rate: 34%. You have decided that the appropriate discount rate the acquisition is 12%. You are going to project cash flows out seven years and then use future growth rate from that point to assess a terminal value. Below is your assessment of uncertainty involving the factors that will eventually impact your cash-flow from this acquisition: 1. Sales Growth: • During Years 1-2 there is a 70% chance that growth will be between 3% and 6%, and a 30% chance that growth will be between 0% and 3%. • During Year 3 there is a 40% chance that growth will be between 3% and 6%, and a 60% chance that growth will be between -3% and 3%. • During Years 4-7 there is a 10% chance that growth will be between 6% and 12%. There is a 40% chance that growth will be between 3% and 6%. There is a 50% chance that growth will be between -3% and 3%. 2. Gross Margin: • If sales decline, there is a 60% chance sales margin will be between 29% and 32%; there is a 30% chance that sales margin will be between 32% and 34%; there is a 10% chance that sales margin will be between 34% and 36%. • If sales growth is positive, there is a 15% chance sales margin will be between 29% and 32%; there is a 50% chance that sales margin will be between 32% and 34%; there is a 35% chance that sales margin will be between 34% and 36%.3. SG&A Expenses: • There is a 30% chance that the change in SG&A expenses will range from -2% to 1%. • There is a 50% chance that the change in SG&A expenses will range from 1% to 4%. • There is a 20% chance that the change in SG&A expenses will range from 4% to 7%. 4. Working Capital: • If sales growth is positive the changes in working capital will equal 15% of sales growth. • If sales growth is negative there is a 40% chance that the change in working capital will equal 15% of sales growth and a 60% chance that the change in working capital will be between 10%-15% of the sales growth. 5. Litigation Liability: • During Year 2 there is a 5% chance of a liability cost that will range between 2 and 3 million dollars. • If there is no liability cost in Year 2, then during Year 3 there is a 5% chance of a liability cost that will range between 2 and 3 million dollars. If Year 2 liability cost is greater than 0, there can be no Year 3 liability cost.6. Terminal Value: • After Year 7 there is a 15% chance the growth rate of free cash flow will be between 0% and 3%; a 60% chance that the growth rate of free cash flow will be between 3% and 6%; a 25% chance that the growth rate in cash-flow will be between 6% and 9%. Develop a detailed Discounted Cash-flow Analysis spread sheet incorporating all these un- certainties and recommend whether this acquisition will create value for your shareholders. (15 Marks) 8. Altman’s ZSCORE Model Altman’s ZSCORE is one of the most famous bankruptcy production models in Finance. The Altman Z-score is calculated as follows: ZSCORE = (1.2× A )+(1.4× B )+(3.3× C )+(0.6× D )+(1.0× E ) where, A = Working Capital/Total Assets, B = Retained Earnings/Total Assets, C = Earnings Before Interest & Tax/Total Assets, D = Market Value of Equity/Total Liabili- ties, E = Sales/Total Assets. A score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3.0 are not likely to go bankrupt. Please use the zscore.dta dataset provided in the Brightspace to calculate the Altman’s ZS- CORE measure for all manufacturing firms in North America. A manufacturing industry is denoted as SIC code between 2000–3999 in the dataset. Once you calculate your ZSCORE measure, please do the following:1. Investigate whether there are any outliers in your ZSCORE variable. If so, winsorize the variable at the 1% level on both tails. Give summary statistics and distributional analysis of your ZSCORE measure. 2. Now calculate additional variables to be incorporated as independent/explanatory variables in your bankruptcy-risk prediction model: logarithm of firm-size, defined as: log(at) ; firms’ future growth opportunity, measured by: Tobin’s q ; book leverage of firms, defined as: dltt/at ; firm-level cash-holding measured by: che/at ; firms’ operating profitability calculated as: ib/sale ; firm-level liquidity, captured by the current ratio: act/dlc ; and a dummy variable indicating whether the firm pays any dividend or not. Winsorize all these variables at the 1% level on both tails. Give a table of summary statistics for all these explanatory variables. 3. Now estimate a simple OLS regression model, where ZSCORE is the dependent vari- able and all variables you calculated in the previous step are independent variables. Make sure that you have winsorized ZSCORE and all additional variables at the 1% level before you start estimating your regression. Based on your OLS model, which firm characteristics are more informative about predicting default risk? Next, estimate the same OLS using White’s (1980) heteroscedasticity-corrected standard errors (the robust option in stata). What happens to your conclusion based on the simple OLS results? Now cluster your standard errors by firm and re-estimate your OLS (the cluster option in stata). What happens to your conclusion based on the simple OLS as well as heteroscedasticity-adjusted results?4. So far, you have estimated a pooled regression al model. Now estimate a fixed-effect panel regression model, where each firm has a distinct fixed effect. How does your results differ using a fixed-effect panel model as opposed to a simple OLS model earlier? 5. Now create a new dependent variable, which is a dummy variable. If the ZSCORE measure is below 1.8 the new variable gets “1” and if the ZSCORE measure is above 3 the new dummy variable gets “0”. Next, use the dummy variable as your dependent variable to estimate a LOGIT and a PROBIT model of bankruptcy risk with all your usual independent variables. Do your results vary compared to the simple cross- sectional OLS and fixed-effect panel models? (15 Marks)