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Student Number u___________________
Research School of Finance, Actuarial Studies and Statistics
FINAL EXAMINATION
Semester 1, 2023
FINM1001 Foundations of Finance
Reading Time: 0 minutes
Writing Time: 240 minutes
Exam Conditions:
Centrally scheduled examination
Permitted Materials:
Any
Instructions to Students:
1. Please refer to the Final Examination Information on the course Wattle site and follow the instructions
regarding the exam and submission requirements.
2. This exam paper consists of a total of 5 pages.
3. The exam includes a total of 4 questions. The questions are of unequal value, with marks indicated for
each question. You must attempt to answer all questions.
4. Do not round calculations until providing your final answer to each question. Final answers should be
rounded to 2 decimal places.
5. Include all workings for each question, as marks will not be awarded for answers that do not include
workings.
6. All solutions have to be handwritten. Typing will NOT be accepted.
7. Ensure you include your student number on every page of your submitted exam, and please include
the signed declaration form with your exam solutions.
8. Students are not permitted to collude or consult with any other students or individuals in their answering
of these questions. Diagnostics across the responses will be undertaken to identify where this
requirement has not been complied with, and your signed attestation form must be submitted with this
exam.
Total Marks = 100
This exam will count towards 60% of your grade for the course if you attempted the mid-semester exam and
were awarded a mark that is higher than your grade in this exam. Otherwise this exam is worth 100% of your
final grade for the course.
FINM1001 Final Examination, S1 2023 2
Question 1 (16 marks)
a) Your uncle is planning to retire in exactly 25 years. After he retires, he wishes to withdraw
$60,000 every six months for 15 years (hint: there will be 30 cash payments of $60,000). At the
end of these 15 years, he has decided that he will enter a retirement home where he will stay
for the remainder of his life. As soon as he enters the retirement home, he will need to make a
single payment of $1.5 million. This payment to the retirement home occurs at the same time as
you receive the last $60,000 payment. If your uncle wants to start saving in an account that pays
interest of 6% p.a. compounded monthly, what should the equal fortnightly deposits be for your
uncle? In addition to this, you are given the following information: (16 marks)
i. The first payment into the saving account will occur in exactly one fortnight’s time;
ii. The first withdrawal of $60,000 is exactly six months after your uncle retires;
iii. Your uncle expects to receive a one-off $750,000 at t=25 years from a cash insurance
policy that your uncle already owns. This will be deposited in his retirement account; and,
iv. All payments are made at the end of the period.
Question 2 (26 marks)
Students are to answer ALL parts of this question.
a) You are considering investing in a special type of bond, which is being issued with a maturity
of 10 years. The coupons are paid semi-annually for the first 5 years and then are paid
quarterly for the final 5 years of the bond. You have been provided with the following
information (assume bond conventions apply as taught):
Name Special Bond
Yield (years 1-5) 7.2% p.a.
Coupon Rate(years 1-5) 4.8% p.a.
Coupon Frequency(years 1-5) Semi-Annually
Yield(years 6-10) 5.6% p.a.
Coupon Rate(years 6-10) 6.4% p.a.
Coupon Frequency(years 6-10) Quarterly
Face Value $500,000
Time to Maturity 10 years
Using the above information, calculate the issue price of the bond. (16 marks)
b) You are discussing the Capital Asset Pricing Model (CAPM) with your friend, detailing the
seven intuitive steps to derive the model. Your friend tells you they understand concepts
better if they are drawn in pictures. Given this:
i. Graphically depict the relationship described by the CAPM given that the risk-free rate is
8% p.a. compounded semi-annually, and the market risk premium is 4% p.a. In providing
your answer ensure that the graph is labelled correctly, including any significant points of
reference. (4 marks)
FINM1001 Final Examination, S1 2023 3
ii. You are given the following information regarding two risky assets. Calculate each of their
expected returns and plot them on your graph, assuming the standard deviation of the
market is 6% p.a. (4 marks)
iii. Your friend then asks you about another asset, namely, Purple, which has the same
characteristics as the Red asset, but has an expected return of 12.5% p.a. Plot this on the
graph. Is Purple a desirable investment? Why or why not? (2 marks)
i. Finally, your friend asks about another asset, Yellow, which has the same characteristics
as the Blue asset, but has an expected return of 12.8% p.a. Plot this on the graph. Is
Yellow a desirable investment? Why or why not? (2 marks)
Question 3 (24 marks)
Students are to answer ALL parts of this question.
Pluto Plus Pens is deciding when to replace its old machine. The old machine’s current salvage value
is $1.3 million. Its current book value is $1 million. If not sold, the old machine will require
maintenance costs of $400,000 at the end of the year for the next five years. Depreciation on the
old machine is $200,000 per year. At the end of five years, the old machine will have a salvage value
of $200,000 and a book value of $0.
A replacement machine costs $500,000 now and requires maintenance costs of $250,000 at the end
of each year during its economic life of five years. If the machine is replaced, the cost of removing
the old machine will cost $50,000, expensed immediately. The new machine will be depreciated to
an estimated salvage value of zero by straight-line method.
In 5 years, another replacement machine will cost $3,500,000. Pluto will need to purchase this
machine regardless of what choice it makes today.
Pluto Plus Pens' project risk is very similar to Chomp & Momo Inc.’s risk, which is currently financed
by 180,000 shares worth $12.50 each, and $750,000 worth of debt. The beta of Chomp & Momo’s
stock is 1.3, and the company borrows at a rate of 10% (before tax). The risk-free rate in the
economy is 6% p.a., and the expected return on the market is 9.5% p.a. The current corporate tax
rate is 30%.
Importantly, Pluto Plus Pens is assumed to earn sufficient revenues to generate tax shields from
depreciation. Further, irrespective of the option undertaken, all other revenues and expenses will
be unaffected. Should Pluto Plus Pens replace the old machine now or at the end of five years? Why
or why not?
Given this information, answer the following:
a) What is the required rate of return on Pluto Plus Pens? (4 marks)
b) Do you recommend Pluto Plus Pens to replace the machine now, or in five years’ time? Why
or why not? (20 marks)
Asset Standard Deviation Correlation (between Asset and the market)
Red 8% p.a. 0.6
Blue 10% p.a. 0.81
FINM1001 Final Examination, S1 2023 4
Question 4 (34 marks)
Students are to answer ALL parts of this question.
a) It is June 2023 and you are the Vice President in charge of risk management for JuicyJuz Inc,
a juice company that produces and supplies juice around the world. One of your biggest
sellers internationally is frozen concentrated orange juice, and as such, it is your job to
monitor the market and protect your future sales, ensuring the highest possible price is
received. You are currently concerned about a big sale in September 2023 of 120,000 pounds
of frozen concentrated orange juice, and you are considering a few different derivatives to
protect your sale.
You have been provided with the following information about the futures and options
contracts on frozen concentrated orange juice (commodity code: FCOJ) (Please note, the
options contract’s underlying asset is the frozen concentrated orange juice futures contract):
Contract Specifications: FCOJ, ICE Futures & Options
Contract Size 15,000 pounds
Price Quotation Cents and Hundredths of a cent (to two
decimal places) e.g. if the contract price is
200, that equals 200c, or $2 per pound.
Contract Months Jan, Mar, May, Jul, Sep, Nov
Last Trading Day One business day prior to the last notice
day
Delivery Physical
To protect the company against adverse movements in frozen concentrated orange juice,
you have decided to utilise one of the following derivatives to put a floor in the amount you
will receive for your sale in September. The following derivatives are available:
 A Futures contract, expiring in July 2023, with a price of 217.50;
 A European put option, expiring in July 2023, with a strike price of 219.00;
 A Futures contract, expiring in September 2023, with a price of 212.25; or
 A European call option, expiring in September 2023, with a strike price of 215.00;
 A European put option, expiring in September 2023, with a strike price of 215.00.
Given this information and the information provided in the tables above, answer the following
questions:
i. Using one of the derivatives above, how would you create a floor in the sale of
120,000 pounds of frozen concentrated orange juice? In providing your answer, show
that your strategy works if the frozen concentrated orange juice in September 2023
FINM1001 Final Examination, S1 2023 5
is 220.00 or 195.00. Be sure to mention any assumptions, if necessary. When
expressing your answer, use dollars and cents (not just cents!). (12 marks)
ii. In trying to protect the sale of frozen concentrated orange juice, you believe you have
identified a mispricing in one of the frozen concentrated orange juice futures
contracts, and think you could exploit this mispricing to generate further profit for
the firm. Specifically, you identify that the July 2023 futures contract, with a price of
217.50 is mispriced in some way. Given the current price of frozen concentrated
orange juice is 210.35 cents today, the risk-free rate is 4.5% p.a. and the cost of
storage is 2.8% p.a. does an arbitrage opportunity exist? If so, show how you could
exploit the arbitrage opportunity (including a table of cash flows). In performing this
strategy, you should assume that there are exactly 7 weeks until the expiration of the
futures contract. (8 marks)
b) A-Team Funds Managers are interested in a particular option strategy, known as a long
straddle, to take advantage of potential volatile movements in Atlas Ltd, a certain stock they
invest in. They are unsure of the payoffs relating to a long straddle and have approached you
to assist them. You are given the following information:
 A long straddle is a strategy involving the simultaneous purchase (long position) in both
a European call option and a European put option which have the same underlying asset,
strike price and expiration date;
 The strike price for both the call and put option in Atlas Ltd is $32.50; and,
 The put premium is $2.85 and the call premium is $1.65.
Answer the following:
i. Draw separate profit diagrams at maturity for a long European call option and a long
European put option in Atlas Ltd. In providing your answer ensure you label all diagrams
adequately (including the numbers provided in the question) (4 marks);
ii. Combine the diagrams you have drawn in part i. to create an overall profit diagram for a
long straddle in Atlas Ltd (4 marks); and,
iii. Calculate the profit of this strategy if at expiration the stock price for Atlas Ltd is $20.
What is the profit of the strategy if the stock price for Atlas Ltd is $45 at expiration (6
marks)?