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UNIVERSITY OF CALIFORNIA, DAVIS DEPARTMENT OF ECONOMICS FINANCIAL ECONOMICS SPRING 2011 PROFESSOR LARSEN MIDTERM EXAM 2

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Important Notes
1. There are 7 pages to this exam (including this cover sheet). Please make sure that you have them all!! 2. Show ALL of your work. Random guesses, without accompanying work, will not receive credit. 3. Please circle your final answers. 4. If you get stuck with the math and cant figure out why, explain what you would do to answer the question. If correct, you will receive partial credit. 5. Budget your valuable time. If you are bogged down on something, it may be best to move on and return to it if you have time at the end of the exam. 6. Finally, when in doubt, use the force, it will guide you

There are 90 points possible

Multiple Choice Section (3 points each) (No Partial Credit in this section)
1. You wish to earn a return of 13% on each of two stocks, X and Y. Stock X is expected to pay a dividend of \$3 in the upcoming year while Stock Y is expected to pay a dividend of \$4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The price of stock X _____. A. will be greater than the price of stock Y B. will be the same as the price of stock Y C. will be less than the price of stock Y D. Not enough information E. None of these is correct. 2. The present value of growth opportunities (PVGO) is equal to I) the difference between a stock's price and its no-growth value per share. II) the stock's price. III) zero if its return on equity equals the required return rate. IV) the plowback ratio times the return on equity. A. I and IV B. II and IV C. I, III, and IV D. II, III, and IV E. I and III 3. You are considering acquiring a common stock that you would like to hold for one year. You expect to receive both \$2.50 in dividends and \$28 from the sale of the stock at the end of the year. The maximum price you would pay for the stock today is _____ if you wanted to earn a 15% return. A. \$23.91 B. \$24.11 C. \$26.52 D. \$27.50 E. None of these is correct 4. Investors want high plowback ratios A. for all firms. B. whenever ROE > r. C. whenever r > ROE. D. only when they are in low tax brackets. E. whenever bank interest rates are high.

5. Low P/E ratios tend to indicate that a company will ______, ceteris paribus. A. grow quickly B. grow at the same speed as the average company C. grow slowly D. P/E ratios are unrelated to growth E. None of these is correct 6. Consider a risky portfolio, A, with an expected rate of return of 0.15 and a standard deviation of 0.15, that lies on a given indifference curve of a risk averse individual. Which one of the following portfolios might lie on the same indifference curve? A. E(r) = 0.15; Standard deviation = 0.20 B. E(r) = 0.15; Standard deviation = 0.10 C. E(r) = 0.10; Standard deviation = 0.10 D. E(r) = 0.20; Standard deviation = 0.15 E. E(r) = 0.10; Standard deviation = 0.20 7. The certainty equivalent rate of a portfolio is A. the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio. B. the rate that the investor must earn for certain to give up the use of his money. C. the minimum rate guaranteed by institutions such as banks. D. the rate that equates "A" in the utility function with the average risk aversion coefficient for all risk-averse investors. E. represented by the scaling factor "-.005" in the utility function. 8. You invest \$100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.09? A. 85% and 15% B. 75% and 25% C. 67% and 33% D. 57% and 43% E. cannot be determined 9. The Capital Market Line I) is a special case of the Capital Allocation Line. II) represents the opportunity set of a passive investment strategy. III) has the one-month T-Bill rate as its intercept. IV) uses a broad index of common stocks as its risky portfolio. A. I, III, and IV B. II, III, and IV C. III and IV D. I, II, and III E. I, II, III, and IV

10. Other things equal, diversification is most effective when A. securities' returns are uncorrelated. B. securities' returns are positively correlated. C. securities' returns are high. D. securities' returns are negatively correlated. E. both securities' returns are positively correlated and securities' returns are high.

Derivation Section 1. [35 Points]

Two firms, Eva Industries and Porter Inc, are both worth \$100 million dollars and have 1 million shares outstanding. Both firms have investors that expect a required return of 8%. Eva Industries return on equity is 10% while Porter Incs is 6%. Answer the following questions about them: a. (10 pts) What are next periods earnings for each of the firms? Assume they each pay out all of the earnings they make each period. What will each firms growth be? What is each of their prices per share? For Eva Industries. E(rE)=100*.10=\$10 Million or \$10 per share gE=0 (bE=0 and g=b*ROE) Since they payout everything the dividends will be the earnings and prices will be found using the no growth dividend formula (perpetuity) PE=DE/r=10/.08=\$125 Similarly for Porter Inc. EP=100*.06=\$6M gP=0 PP=6/.08=\$75

b. (10 pts) Now instead of paying out all of their dividends Eva Industries keeps an earnings retention ratio of 50% and Porter Inc keeps an earnings retention ratio of 75%. What is the new growth rate of each company? What are the dividends per share for each? What are prices per share for each company? Given the info above bE=.5 Growth is found by multiplying the return on equity by the plowback or earnings retention ratio. gE=ROEE*bE =.1*.5 =.05 or 5% Dividends paid out are the earnings that arent kept by the firm. DE=EE(1-bE) =10*.5 =\$5 Price is found using the Gordon Growth Model Formula PE=DE/(r-gE) =5/(.08-.05)=\$166.67 Similarly for Porter Inc. bP=.75 gP=.06*.75=.045 or 4.5% DP=6*(1-.75)=\$1.5 PP=1.5/(.08-.045)=\$42.86

c. (10 pts) What plowback ratio should each firm keep in order to get the highest price possible? What Price would each firm get at that ratio? Eva should have a plowback ratio of 1 or 100% because their ROE is greater than the required return ratio. When this happens it is better for the company to reinvest as much as possible. There were two possible answer for the price with this ratio. A price of infinity would suffice. Or stating that we cannot tell because the Gordon growth model doesnt apply when g>r would also work. For Porter, the plowback ratio should be 0% because ROE<r. They cant make as much as people require so they should just pay it all out to investors. Part a of this problem had a plowback of 0 so the price would be the same as it was there, \$75.

2. [30 points]
Assume there are only two portfolios in the world. A risk free portfolio with a return of 6% and a risky portfolio with a return of 14% and a standard deviation of 22%. Assume you have a risk aversion factor of 3. Throughout this problem you may assume the usual utility curve U=E(r)-1/2A2 a. (10 pts) Assume you can only invest all of your money in one portfolio. Which portfolio would you choose? What would the risk-free rate have to be to make you indifferent between it and the risky portfolio? Just compare the utilities of each asset separately. U(rf)=.06-1/2*3*02=.06-0=.06 U(rp)=;14-1/2*3*.222=.0674 U(rP)>U(rf) so you prefer the risky asset. The risk-free rate that would make you indifferent is just the certainty equivalence or the utility given by the asset you chose (the risky asset). So the return should be 6.74%.

b. (10 pts) Now assume that you can split your money between the two portfolios in any way you like. However, if you want to invest more than 100% in the risky asset you must borrow at a rate of 8%. Draw the Capital Asset Line associated with this below. Label all axis and the points and values that correspond to the risky and risk-free portfolio. What is(are) the slope(s) of this line? Recall the Slope of the CAL is (E(rP)-rf)/P=(.14-.06)/.22=.36 But here you cannot borrow at the risk free rate you can only borrow at rb=.08. So there is a kink point at the part where you need to borrow money (to the right of 100% of money in the risky asset) There the slope is (E(rP)-rb)/P=(.14-.08)/.22=.27 See the figure below.

c. (10 pts) What is your optimal fraction of your investments that you would hold in each portfolio? What is the expected return, standard deviation and 5% VaR of the optimal portfolio? (You may find the following useful: -1.65, and -2.33 are the 5th and 1st percentile of a normal distribution). The formula for optimal risky share is: E ( rp ) rf .14 .06 y* = = = .55 2 A P 3* .22 2 Thus you should hold 55% in risky and 45% in risk-free.

c = y * P = .55 * .22 = .121 or 12.1%

The VaR for 5% level is E(r)-1.65* So .104-1.65*.121=-.09565 = -9.6% So the best worst case scenario is a return of -9.6%.