MIT Sloan School of Management Summer 2018

Gervais and Kogan 15.415

15.415 – Final Exam

Instructions:
• Do not go beyond this page until you are told to do so. Carefully read the
instructions below.

• Please write your name and MIT ID number, and check your section (A or B) at the
bottom of this page. During the exam, you will also have to write your name and MIT
ID number at the top of every page.

• The exam lasts 170 minutes. It consists of nine questions. Please answer all of them,
and do so without consulting anyone.

• Credit for each question is approximately equal to the amount of time you should
spend on it (1 point = 1 minute). Therefore, do not agonize over a 5-point question
at the risk of running out of time to work a 20-point question.

• You are allowed to use two (two-sided) 8 21 × 11” sheets of formulas and a calculator.
No email-capable device is allowed.

• Use the space provided in the exam. If more space is needed, use the extra pages
provided at the end of the exam.

• Show your work. Answers whose origin is unclear receive no credit. Partial credit will
be given for partially correct solutions provided that we can assess your reasoning.

Good luck!

Name: MIT ID:

Section (check one): A B

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15.415 – Final Exam

Grade Sheet

Question Score

Question 1 (25 pts)

Question 2 (20 pts)

Question 3 (15 pts)

Question 4 (20 pts)

Question 5 (20 pts)

Question 6 (15 pts)

Question 7 (10 pts)

Question 8 (15 pts)

Question 9 (30 pts)

Total (170 pts)

Summer 2018 15.415 – Final Exam Grade Sheet

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1. (25 points total) Indicate which of the following statements are true and which are
false by checking the appropriate box. Please explain your answer; answers without
explanation receive no credit. (5 points each)

(a) True or False . By the CAPM, stocks with the same beta have the same
variance.

(b) True or False . The forward price equals the markets expectation of the fu-
ture spot price.

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(c) True or False . Depreciation reduces earnings, and thus a faster depreciation
schedule reduces the value of the firm’s equity.

(d) True or False . The weak form of market efficiency implies that a momentum
strategy of buying last-periods winners cannot earn positive expected abnormal
returns.

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(e) True or False . Assume that CAPM holds. Firms with higher equity betas
have higher weighted average cost of capital for projects that are similar in risk
to the firm itself.

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2. (20 points total) The Sisao Corporation is planning to acquire Rulb Incorporated (i.e.,
it is planning to acquire all of Rulb’s assets). Rulb is financed with debt and equity
which are currently worth $40 million and $160 million respectively. The rate at which
Rulb is able to borrow is 7%, and the beta of its stock is 1.2.
Sisao is also financed with debt and equity. Its debt is worth $100 million, and its equity
is worth $900 million. Currently, Sisao’s debt is risk-free, and the beta of Sisao’s assets
is 0.76. The acquisition of Rulb will be financed entirely with the issuance of more
debt. Following the acquisition, Sisao’s total debt will be riskier and so will require an
expected return of 8%.
For your calculations, assume that Rulb’s assets will be acquired at their market value,
that there are no synergies or cost savings resulting from the acquisition, and that there
are no market imperfections (e.g., there are no taxes). Also assume that the risk-free
rate is 5%, that the expected return on the market portfolio is 15%, and that the
CAPM holds.

(a) (6 points) What are the beta and the expected return of Rulb’s assets?

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(b) (6 points) What are the beta and the expected return of Sisao’s equity before the
acquisition of Rulb?

(c) (8 points) What are the beta and the expected return of Sisao’s equity after the
acquisition of Rulb?

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3. (15 points total) Consider a market with two possible states a year from now: Boom
or Bust. In the Boom state, the return on the stock market portfolio is 25%, versus
−25% in the Bust state. The one-year risk-free rate is 5%. The probability of the
Boom state is 70%.
Consider a corporate bond. This is a zero-coupon bond, maturing one year from now.
The face value of the bond is $100. In the Boom state, the bond has a 2% probability of
default, and the recovery ratio is 60% (the bond pays off 60% of the promised amount).
In the Bust state, the bond has a 10% probability of default, and the recovery ratio is
40%.

(a) (2 points) Compute the expected payoff of the bond in each of the two states a
year from now.

(b) (4 points) Determine the risk-neutral probabilities of the Boom and Bust states.

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(c) (2 points) Compute the price of the corporate bond at time 0.

(d) (3 points) Compute the bond’s (expected) yield, promised yield, and risk pre-
mium.

(e) (4 points) Suppose that the CAPM holds. Based on one-year returns, what is the
market beta of the corporate bond in this question?

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4. (20 points total) The General Everything Corporation (GE) will cease to operate in one
year. The firm is currently all-equity financed, and has 10 million shares outstanding.
In one year, GE’s projects will generate earnings before interest and taxes of $90 mil-
lion, $180 million or $225 million with equal probabilities (in the Bad, Medium and
Good states respectively). Assume that the physical assets are completely worthless
in all three states of the world at that time. The risk is all idiosyncratic, and so all
cash flows can be discounted at the same risk-free rate of 20%. The corporate tax rate
is 20%.

(a) (4 points) What is the current value of its equity?

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The firm is considering a debt issue whose proceeds will be used to repurchase some of
its equity. Two sizes are being considered for this one-year debt contract: a promised
payment of $60 million or a promised payment of $120 million. When the firm must
default on its debt, it is anticipated that 80% of the available money will be loss to
bankruptcy frictions (e.g., legal costs). To simplify calculations, assume that the entire
payment on the debt (not just the interest payment) is tax deductible.

(b) (6 points) Suppose that GE chooses the debt with the $60 million promised pay-
ment. After the debt issue and equity repurchase, what is the value of the debt,
the value of the equity, and the total value of the firm?

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(c) (6 points) Suppose instead that GE chooses the debt with the $120 million
promised payment. After the debt issue and equity repurchase, what is the value
of the debt, the value of the equity, and the total value of the firm?

(d) (4 points) What is the optimal financing of the firm if the only options are: no
debt, debt with a $60 million face value, or debt with a $120 million face value?
Intuitively explain why (in 2-3 sentences).

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5. (20 points total) Roam Depot Inc. is an unlevered firm that generates an after-tax
free cash flow stream which is expected to be $250 million, and is expected to grow
at a rate of 4% per year. The beta of the unlevered value of this cash flow stream is
βA = 1.5. The risk-free rate of interest is 6%, and the risk premium on the market
portfolio is 7%. The corporate tax rate is 40%. Assume all debt is risk-free (and so
the cost of debt is 6%). You are asked to do the following.

(a) (5 points) Calculate the value of the unlevered firm.

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(b) (7 points) Using WACC, calculate the value of the levered firm, under the as-
sumptions that the firm levers itself to a 50% (market) debt-to-value ratio and
that the debt is constantly rebalanced.

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(c) (8 points) You decide to change your assumption about the firm’s debt (i.e., this
question does not build onto part b). Using APV, calculate the value of the
levered firm which borrows $2 billion. Assume that the principal on the loan
will be repaid in four equal installments in each of years 1, 2, 3, 4 (i.e., each
year, the company pays 14 of the principal and, in addition, pays the interest on
the outstanding loan), and that the firm remains an unlevered firm forever after
year 4. Also, assume that the interest rate on the debt remains at 6%.

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6. (15 points total) Bio-Egen Inc. is a technology firm working on a new technology for
producing electricity. There are two possible development strategies. One requires an
upfront investment of $100M, requires a year of effort, and has a 24% probability of
success. If successful, this technology will produce a perpetual risky stream of cash
flows of $50M per year, starting in year 1. Otherwise, it produces $0.
The second strategy takes two years, and involves two stages of investment. The first
stage, which starts at time 0 and takes one year to complete, requires an investment
of $30M and has a probability of success of 20%. The second stage starts at time 1
and takes one year to complete.
If the first stage is successful, the second stage has a probability of success of 80%.
Otherwise, the second stage has a probability of success of only 10%. In both cases,
the second stage requires an investment of $90M. If successful, this technology will
produce a perpetual risky stream of cash flows of $50M per year, starting in year 2.
Assume that the project’s risk is completely idiosyncratic, and thus the appropriate
discount rate for all cash flows is the risk-free rate, which is 10% per year.
The two strategies are mutually exclusive: once the firm starts on one, it cannot pursue
the other later on.

(a) (4 points) Suppose that, if Bio-Egen decides to pursue strategy 2, it must commit
to both stages at time 0. What is the eventual probability of success of the second
strategy?

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(b) (5 points) Under the assumptions of part (a), compute the NPV of both develop-
ment strategies. Which strategy should the firm choose?

(c) (6 points) Suppose instead that, if following strategy 2, the firm has flexibility to
shut down the development process after the first stage. Compute the NPV of
development strategy 2 under this assumption. Which strategy should the firm
choose?

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7. (10 points) Champion Energy, a privately owned electricity provider based in Houston,
is considering the possibility of expanding its operations in the Northwest, and you have
been hired to advise the company about the cost of capital for this new project.
To estimate this cost of capital, you have gathered data on comparable electric utilities
companies that are publicly traded, IdaCorp Inc. (IDA) and Portland General Electric
Company (POR), both of which borrow at the risk-free rate.

IDA POR
Debt (D, in $million) 1,200 1,500
Equity (E, in $million) 4,000 3,000
Equity Beta (βE ) 1.15 1.50

You also estimate that the debt capacity of the new project corresponds to a debt-to-
value ratio of 0.40. Debt supported by this project will be risky, and will require the
expected return of rD = 5.6%.
The corporate tax rate (which all three firms are subject to) is 50%. The risk-free rate
is 4%, and the market risk premium is 8%. Assume that all debt is permanent (i.e.,
never rebalanced).
Use both comparable firms (with equal weights applied to the appropriate quantity)
to estimate the WACC for the project.

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8. (15 points total) The non-dividend-paying stock of Stone Crusher Co. is currently
trading at $100. You’ve been quoted market prices for the following European put
options on Stone Crusher Co. with 6 months to maturity and different strikes:

Strike Price Put Price

90 3.41
95 5.19
100 7.43
105 10.13
110 13.26

A digital put option D pays one dollar 6 months from now if the stock price at that
time is below the strike price of $100. It pays nothing otherwise. The price of the
digital put on Stone Crusher Co. is quoted at $0.60.

(a) (2 points) Draw the payoff diagram for digital put D.

(b) (4 points) Draw the payoff diagram of the following combination of options: 10 dig-
ital puts D and 1 European call with the same strike price of $100.

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(c) (9 points) Demonstrate that digital put D is overvalued relative to the put options.
Construct a trading strategy that locks in an arbitrage profit. You can use the
underlying stock and the above put options to form your portfolio.

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9. (30 points total) Suppose that the global market portfolio consists of a portfolio of
the stocks of developed economies and a portfolio of the stocks of emerging economies.
Suppose that the CAPM holds with the market being the global market portfolio.
The portfolio of developed economy stocks has an expected return rD = 8% and the
portfolio of emerging economy stocks has an expected return rE = 11%. The standard
deviations are σD = 25% and σE = 50% and the correlation between the two is ρDE =
0.5. Finally, the risk-free rate is 3%.
Assume that the composition of the (global) market portfolio has a weight of 80%
in the portfolio of developed economy stocks and 20% in the portfolio of emerging
economy stocks.

(a) (6 points) Compute the expected return on the (global) market portfolio (rm ), the
standard deviation of the (global) market portfolio (σm ), and the Sharpe ratio of
the (global) market portfolio (SRm ).

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(b) (5 points) Determine the beta of the portfolio of developed economy stocks (βD ),
the beta of the portfolio of emerging economy stocks (βE ), and the beta of the
(global) market portfolio (βm ).

(c) (6 points) Your client has $100 million invested, 60% of which is in the portfolio of
developed economy stocks, and the rest in risk-free assets. What is the expected
return rp , volatility σp , Sharpe ratio SRp , and beta βp of your client’s portfolio?

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(d) (6 points) Keeping the volatility of her portfolio the same, can your client achieve
a higher expected return? If so, what portfolio do you advise your client invest
in? Compute the expected return rep of that portfolio, as well as its Sharpe ratio
SRep and beta βep . How much money will your client invest in the risk-free asset,
the portfolio of developed economy stocks, and the portfolio of emerging economy
stocks if she follows your advice?

(e) (7 points) Show that the portfolio with a weight of 80% in the portfolio of devel-
oped economy stocks and 20% in the portfolio of emerging economy stocks is the
tangent portfolio.

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MIT Sloan School of Management Summer 2018
Gervais and Kogan 15.415

15.415 – Final Exam Solutions

1. (25 points total)

(a) (5 points) FALSE. Even though these stocks’s systematic risk is the same, they
may have different idiosyncratic risk. Since the variance (and standard deviation)
of a stock is affected by both, stocks with the same beta do not necessarily have
the same variance.
(b) (5 points) FALSE. Take an asset whose convenience yield net of storage costs is
zero. The T -year forward price is then FT = S0 (1 + rf )T , where rf is the risk-free
rate. If we denote the expected return of the underlying asset by r̄, the expected
price at T of the underlying asset is E[S̃T ] = S0 (1 + r̄)T . Thus, we can rewrite
the futures price as
 T
1 + rf
FT = E[S̃T ],
1 + r̄
which is different from E[S̃T ] unless the underlying asset’s risk is fully diversifiable.
(c) (5 points) FALSE. Depreciation does reduce earnings and, in turn, the firm’s
taxes. However, because it is not a cash cost, its net effect on a firm’s (free)
cash flows is to add a tax shield. Thus any accelerated (i.e., larger and earlier)
depreciation increases the firm’s early cash flows and, because of the time value
of money, has a positive impact on the firm’s value and the firm’s equity.
(d) (5 points) TRUE. The weak form of market efficiency says that all information in
past prices is reflected in current prices, and thus past prices cannot be used to
generate abnormal returns. Since momentum strategies condition on the evolution
of past prices, they should not generate abnormal returns if weak-form efficiency
holds.
(e) (5 points) FALSE. A firm’s weighted average cost of capital (WACC) is a weighted
average of its cost of equity capital and its (after-tax) cost of debt capital. Thus
although a higher equity beta means a higher cost of equity capital, the size of the
WACC generally depends on the firm’s debt-to-value ratio and its cost of debt.

2. (20 points total) For this question we are given rf = 5% and rm = 15%.

(a) (6 points) For Rulb, we have D R = 40, E R = 160, rD

R
= 7%, and βER = 1.2. Using
the CAPM, we can find

rER = rf + βER (rm − rf ) = 0.05 + (1.2)(0.15 − 0.05) = 17%,

Summer 2018 15.415 – Final Exam Solutions Page 1 of 10

 and
R R R R
rD = rf + βD (rm − rf ) ⇔ 0.07 = 0.05 + βD (0.15 − 0.05) ⇒ βD = 0.2.

This implies that

DR ER
rAR = r R
+ rR
DR + E R D DR + E R E
40 160
= (0.07) + (0.17) = 15%,
40 + 160 40 + 160
and
DR ER
βAR = β
R D
R
+ βR
R E
D +E
R
D +E
R

40 160
= (0.2) + (1.2) = 1.0.
40 + 160 40 + 160

(b) (6 points) For Sisao, we have D S = 100, E S = 900, βD

S
= 0, and βAS = 0.76.
Therefore,
DS ES
βAS = β
S D
S
+ βS
S E
D +E
S
D +E
S

100 900
⇔ 0.76 = (0) + βES
100 + 900 100 + 900
⇒ βES = 0.8444.

Using the CAPM, this implies that

rES = rf + βES (rm − rf ) = 0.05 + (0.8444)(0.15 − 0.05) = 13.44%.

(c) (8 points) After Rulb is acquired for $200 million, Sisao will have $1,200 million
in assets: $1,000 million from its old operations (βAold = 0.76), and $200 from Rulb
(βAR = 1.00). Sisao’s new asset beta can therefore be calculated as:
1,000 200
βAnew = (0.76) + (1.00) = 0.80.
1,000 + 200 1,000 + 200
Now Sisao’s debt is worth $300 million, and its equity is still worth $900 million.
We can also use the CAPM to find Sisao’s debt beta:
S S S S
rD = rf + βD (rm − rf ) ⇔ 0.08 = 0.05 + βD (0.15 − 0.05) ⇒ βD = 0.3.

Therefore,
300 900
0.8 = (0.3) + βS ⇒ βES = 0.9667.
300 + 900 300 + 900 E
Finally, using the CAPM, we have

rES = rf + βES (rm − rf ) = 0.05 + (0.9667)(0.15 − 0.05) = 14.67%

Summer 2018 15.415 – Final Exam Solutions Page 2 of 10

 3. (15 points total)

(a) (2 points) The expected payoff of the bond in each of the two states is

E[CFBoom ] = 0.98(100) + 0.02(60% × 100) = 99.20,

E[CFBust ] = 0.90(100) + 0.10(40% × 100) = 94.00.

(b) (4 points) First, we compute risk-neutral probabilities of the Boom and Bust
states. Based on the distribution of stock returns across these two states, the
risk-neutral probabilities q of the Boom state is

(1 + rf ) − d 1.05 − 0.75
q= = = 60%.
u−d 1.25 − 0.75
Notice that, since the expected return on the stock market is

rm = (0.70)(25%) + (0.30)(−25%) = 10%,

we could have calculated q by solving for it in

q(1.25) + (1 − q)(0.75)
= 1.
1.05

(c) (2 points) The bond price is

0.6 × 99.20 + 0.4 × 94.00
B0 = = 92.50.
1.05

(d) (3 points) The promised yield is

100
YTBpromised = − 1 = 8.11%.
92.50
The expected yield is
97.64
YTBexpected = − 1 = 5.56%.
92.50
The risk premium is then

Risk Premium = 5.56% − 5% = 0.56%.

(e) (4 points) According to CAPM, the market beta of a asset is proportional to its
risk premium. The beta of the market is one, and its risk premium is rm − rf =
10% − 5% = 5%. Therefore, the beta of the bond is given by

0.56%
βB = = 0.1124.
5%

Summer 2018 15.415 – Final Exam Solutions Page 3 of 10

 4. (20 points total)

(a) (4 points) The after-tax earnings of the firm are EBIT (1 − tc ), which are 90(1 −
0.20) = 72, 180(1 − 0.20) = 144, and 225(1 − 0.20) = 180 in the bad, medium and
good states respectively. The firm (and its unlevered equity) is worth
1
3
(72) + 31 (144) + 13 (180)
V =E= = 110.
1.20
110
The price per shares is therefore 10
= 11.
(b) (6 points) When a payment is made on the debt, this payment serves to reduces
the taxable profits of the firm. The firm’s earnings are large enough to afford the
promised payment of 60 in all three states, and thus
1
3
(60) + 31 (60) + 31 (60)
D= = 50.
1.20
These debt payments reduce the firm’s taxable profits to 90 − 60 = 30, 180 − 60 =
120, and 225 − 60 = 165 in the bad, medium and good states respectively. After
(corporate) taxes, shareholders receive 30(1 − 0.20) = 24, 120(1 − 0.20) = 96, and
165(1 − 0.20) = 132 in these states. Their equity is therefore worth
1
3
(24) + 13 (96) + 31 (132)
E= = 70.
1.20
The firm’s value is V = D + E = 50 + 70 = 120. Upon the announcement of
the debt issue, the value of the firm goes up to 120, which is $12 per share. This
means that the firm will repurchase $50 $12
million
= 4.17 million shares.
(c) (6 points) When the face value of the debt is 120, the firm defaults in the bad
state as the 90 that its operations generate is not sufficient to cover the promised
payment on the debt. In that state, the debtholders receive only 90(1−0.80) = 18
after the bankruptcy costs are paid. They receive a full 120 in the medium and
good states. Therefore, their debt is worth
1
3
(18) + 31 (120) + 13 (120)
D= = 71.67.
1.20
These debt payments reduce the firm’s taxable profits to zero, 180 − 120 = 60,
and 225 − 120 = 105 in the bad, medium and good states respectively. After
(corporate) taxes, shareholders receive zero, 60(1−0.20) = 48, and 105(1−0.20) =
84 in these states. Their equity is therefore worth
1
3
(0) + 13 (48) + 31 (84)
E= = 36.67.
1.20
The firm’s value is V = D + E = 71.67 + 36.67 = 108.33. Upon the announcement
of the debt issue, the value of the firm goes down to 108.33, which is $10.83 per
share. This means that the firm will repurchase $71.67 million
$10.83
= 6.62 million shares.

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 (d) (4 points) The firm will choose the debt with a face value of $60 million, as its
value is maximized with such a capital structure. Intuitively, the firm benefits
from tax shields as it increases the debt from zero to D = 50 (i.e., the debt with a
face value of 60), as this debt allows it to shield profits from taxes without forcing
it to default and incur bankruptcy costs. When the debt is increased too much,
however, the firm must default in the bad state of the world. Although the tax
shields get larger, the large bankruptcy costs associated with default more than
offset the tax shield benefits.

5. (20 points total)

(a) (5 points) We use the CAPM to compute the discount rate for the all-equity firm:
rA = rf + βA (rm − rf ) = 0.06 + 1.5(0.07) = 16.5%.
The value of the unlevered firm is therefore
FCF1 250
VU = = = 2,000.
rA − g 0.165 − 0.04
(b) (7 points) The beta of the levered equity is given by
   
D D 0.50
βE = βA + (βA − βD ) = 1 + βA = 1 + 1.5 = 3.0,
E E 0.50
where we used the fact that βD = 0 for risk-free debt. The equity cost of capital
for the levered firm is
rE = rf + βE (rm − rf ) = 0.06 + 3.0(0.07) = 27.0%.
Thus its weighted average cost of capital is
   
D E
WACC = (1 − tc )rD + rE
V V
= (0.50)(1 − 0.40)(0.06) + (0.50)(0.270) = 15.3%.
The value of the levered firm is therefore
FCF1 250
VL = = = 2,212.39.
WACC − g 0.153 − 0.04
(c) (8 points) The adjusted present value (APV) is just the sum of the unlevered NPV
(which is VU as calculated in part (a)) and the present value of the tax shields.
Since the principal borrowing amount is $2 billion, here is the 4-year payback
schedule:

0 1 2 3 4
Debt Outstanding 2,000 1,500 1,000 500 0
Interest Payment 120 90 60 30
Principal Payment 500 500 500 500
Total Payment on the Debt 620 590 560 530
Interest Tax Shield 48 36 24 12

Summer 2018 15.415 – Final Exam Solutions Page 5 of 10

 Thus we have
48 36 24 12
P V (Interest Tax Shields) = + 2
+ 3
+ = 106.98,
1.06 (1.06) (1.06) (1.06)4
and AP V = 2,000 + 106.98 = 2,106.98.

6. (15 points total)

(a) (4 points) The eventual probability of success can be computed from conditional
probabilities in stage 1, given the outcome of the first stage:
Pr{Success of Strat 2} = 0.2 × 0.8 + 0.8 × 0.1 = 0.24.
Thus, it is the same as for strategy 1.
(b) (5 points) For strategy 1:
 
1 $50
NP VStrat 1 = −$100 + 0.24 × 50 + = $20.00.
1.10 0.10
Note that ($50/0.1) + $50 is the time-1 present value of the perpetual cash flow of
$50, starting at time 1. We discount this back to time 0 at the same rate of 10%.
We multiply the time-1 present value by the probability of success, 24%. Success
or failure of the development process is idiosyncratic risk and does not demand a
separate risk premium. For strategy 2, using similar logic, we find
 
$90 1 $50
NP VStrat 2 = −$30 − + 0.24 × 50 + = −$2.73.
1.10 (1.10)2 0.10
(c) (6 points) If the outcome of the first stage is negative, the probability of success
of the second stage is 10%. Then, the time-1 NPV of the second stage is
 
1 $50
NP VStrat 2, Stage 2 = −$90 + 0.10 × 50 + = −$40.00 < 0.
1.10 0.10
In this case, the firm will terminate the development program. If the first stage
is successful,
 
1 $50
NP VStrat 2, Stage 2 = −$90 + 0.80 × 50 + = $310.00 > 0.
1.10 0.10
Thus, the time-0 NPV equals
$310
NP VStrat 2, time 0 = −$30 + 0.2 × = $26.36.
1.1
7. (10 points) We use the comparable firms to get an estimate of βA for the project. We
calculate each comparable firm’s (unlevered) asset by unlevering its equity beta (and
using the fact that each firm’s debt beta is zero):
βEIDA 1.15
βAIDA = IDA = 1,200 = 1.00,
1+ D


E
(1 − tc ) 1 + 4,000
(1 − 0.50)
βEPOR 1.50
βAPOR = POR = 1,500 = 1.20.
1+ D


E
(1 − tc ) 1 + 3,000
(1 − 0.50)

Summer 2018 15.415 – Final Exam Solutions Page 6 of 10

 We use βA = 1.00+1.20
2
= 1.10 for the project. We need to relever this beta to get the
equity beta for the project. Since Champion Energy borrows at rD = 5.6%, we have:

rD = rf + βD (rm − rf ) ⇔ 0.056 = 0.04 + βD (0.08) ⇒ βD = 0.20.

We also know that the project’s debt capacity is D

V
= 0.40, and so the project’s equity
beta is given by
 
D 0.40
βE = βA + (1 − tc )(βA − βD ) = 1.10 + (1 − 0.50)(1.10 − 0.20) = 1.40.
E 0.60

Using the CAPM, we find the cost of equity for the project,

rE = rf + βE (rm − rf ) = 0.04 + 1.40(0.08) = 15.2%,

and finally the weighted average cost of capital for the project,
   
D E
WACC = (1 − tc )rD + rE
V V
= (0.40)(1 − 0.50)(0.056) + (0.60)(0.152) = 10.24%.

Note that the weighted average cost of capital can also be calculated as follows:

rA = rf + βA (rm − rf ) = 0.04 + (1.10)(0.08) = 12.8%

 
D h i
⇒ WACC = 1 − tc rA = 1 − (0.40)(0.50) (0.128) = 10.24%.
V

8. (15 points total)

(a) (2 points) The digital put’s payoff diagram as a function of the stock price in six
months (S1/2 ) is as follows:
Payoff

0
0 100 S1/2

Summer 2018 15.415 – Final Exam Solutions Page 7 of 10

 (b) (4 points) The payoff diagram for this combination of options is as follows:
Payoff

+1

10
0
0 100 S1/2

(c) (9 points) Consider buying a put with a strike price of $105, selling a put with a
strike price of $100, and selling 5 digital puts D. As the following table shows,
this position generates a positive payoff of $0.30 today and a non-negative payoff
at maturity. This is an arbitrage.

Payoff if Payoff if Payoff if

Position Price S1/2 ≤ 100 100 < S1/2 ≤ 105 S1/2 > 105
Buy put @ K = 105 $10.13 105 − S1/2 105 − S1/2 0
Sell put @ K = 100 −$7.43 −(100 − S1/2 ) 0 0
Sell 5 digital puts −5 × $0.60 5 0 0
Total −$0.30 0 105 − S1/2 0

9. (30 points total)

(a) (6 points) The expected return of the market portfolio is

rm = wrD + (1 − w)rE = (0.80)(0.08) + (0.20)(0.11) = 8.6%.

The variance of the market portfolio is

2
σm = w 2σD2 + (1 − w)2 σE2 + 2w(1 − w)ρDEσD σE
= (0.80)2(0.25)2 + (0.20)2 (0.50)2 + 2(0.80)(0.20)(0.5)(0.25)(0.5) = 0.07,

which implies that the standard deviation of the market portfolio is

p √
σm = σm 2 = 0.07 = 26.46%.

Finally, the Sharpe Ratio of the market portfolio is

rm − rf 0.086 − 0.03
SRm = = = 0.2117.
σm 0.2646

Summer 2018 15.415 – Final Exam Solutions Page 8 of 10

 (b) (5 points) The beta of the portfolio of developed economy stocks is obtained from
the Security Market Line, the fact that rD = 8%, and our earlier result that
rm = 8.6%:

rD = rf + βD (rm − rf ) ⇔ 0.08 = 0.03 + βD (0.086 − 0.03) ⇒ βD = 0.8929.

The beta of the portfolio of emerging economy stocks is obtained similarly:

rE = rf + βE (rm − rf ) ⇔ 0.11 = 0.03 + βE (0.086 − 0.03) ⇒ βE = 1.4286.

By definition, the beta of the market portfolio is βm = 1. In fact, because it is

composed of developed economy stocks (wD = 0.80) and emerging economy stocks
(wE = 0.20), we can easily verify this:

βm = wD βD + wE βE = (0.80)(0.8929) + (0.20)(1.4286) = 1.

(c) (6 points) Your client has a fraction w = 0.60 of her money in the portfolio of
developed economy stocks, and the rest of her money invested at the risk-free
rate. The expected return of her portfolio is

rp = wrD + (1 − w)rf = (0.6)(0.08) + (0.4)(0.03) = 6.0%.

The volatility of her portfolio is (where we have made use of the fact that σrf = 0)

σp = wσD = (0.6)(0.25) = 15%.

The Sharpe Ratio of her portfolio is

rp − rf 0.06 − 0.03
SRp = = = 0.20.
σp 0.15
Finally, the beta of her portfolio is

βp = wβD + (1 − w)βrf = (0.6)(0.8929) + (0.4)(0) = 0.5357.

(d) (6 points) The highest Sharpe Ratio can be attained by forming portfolios that
are invested in a combination of the market portfolio and the risk-free asset. The
set of such efficient portfolios lie on the Capital Market Line (CML):
rm − rf
rep = rf + σep . = rf + SRm σep .
σm
Thus, for a volatility of σep = 0.15, your client’s portfolio would have an expected
return of
rep = 0.03 + (0.2117)(0.15) = 6.18% > 6.00%.
This would be obtained by investing a fraction wep of her money in the market
portfolio and 1 − wep in the risk-free asset:

rep = wep rm + (1 − wep )rf ⇔ 0.0618 = wep (0.086) + (1 − wep )(0.03)

⇒ wep = 0.5671.

Summer 2018 15.415 – Final Exam Solutions Page 9 of 10

 That is, your client should invest wep × 100M = 56.71M in the market portfolio.
Recall that this portfolio is itself composed of the portfolio of developed economy
stocks (wD = 0.80) and the portfolio of emerging economy stocks (wE = 0.20).
Thus your client should invest wD ×56.71M = 45.36M in the portfolio of developed
economy stocks and wE × 56.71M = 11.34M in the portfolio of emerging economy
stocks. Since βrf = 0 and σrf = 0, we have
βep = wep βm = wep = 0.5671,
Finally, the portfolio’s Sharpe Ratio is the same as the market portfolio’s Sharpe
Ratio: SRep = SRm = 0.2117. One could also verify this by calculating the Sharpe
Ratio as usual:
rep − rf 0.0618 − 0.03
SRep = = = 0.2117.
σep 0.15
(e) (7 points) Suppose we form a portfolio P that has a weight of w on the portfolio
of developed economy stocks and a weight of 1 − w on the portfolio of emerging
economy stocks. The (random) return of this portfolio is r̃P = wr̃D + (1 − w)r̃E .
We know that the market portfolio will be the tangent portfolio and that, for such
a portfolio, the return-to-risk ratio is the same for all assets in it. The return-to-
risk ratios for the portfolio of developed economy stocks and for the portfolio of
emerging economy stocks are
rD − rf rE − rf
RRRD = and RRRE = ,
σDP /σP σEP /σP
respectively. We can calculate


σDP = Cov(r̃D , r̃P ) = Cov r̃D , wr̃D + (1 − w)r̃E
= wVar(r̃D ) + (1 − w)Cov(r̃D , r̃E ) = wσD2 + (1 − w)σDE
= wσD2 + (1 − w)ρDE σD σE
and, similarly,


σEP = Cov(r̃E , r̃P ) = Cov r̃E , wr̃D + (1 − w)r̃E
= wCov(r̃D , r̃E ) + (1 − w)Var(r̃E ) = wσDE + (1 − w)σE2 .
= wρDE σD σE + (1 − w)σE2 .
Thus RRRD = RRRE is equivalent to
rD − rf rE − rf
= .
wσ 2
D
+ (1 − w)ρDE σD σE wρDE σD σE + (1 − w)σE2
Solving for w, we get
(rD − rf )σE2 − (rE − rf )ρDE σD σE
w=
(rD − rf )(σE2 − ρDE σD σE ) + (rE − rf )(σD2 − ρDE σD σE )
(0.05)(0.5)2 − (0.08)(0.5)(0.25)(0.5)
=    
(0.05) (0.5)2 − (0.5)(0.25)(0.5) + (0.08) (0.25)2 − (0.5)(0.25)(0.5)
= 0.80.

Summer 2018 15.415 – Final Exam Solutions Page 10 of 10