oe P nance Fundamentals ~ MBA Name:__ KEY 2 = Quiz # 6 - Fall 2018 (Dec. 10, 2018) Dé: 3 Total Points: 10 = Ge 1 Which of the following statements is false? eT I 2, standard deviation and beta both measure risk, but beta measures only systematic risk; while standard deviation is a measure of total risk ‘market risk is also referred to as the systematic risk or non-diversifiable risk /~ ©. aportfolio is considered to be efficient if no other portfolio offers higher expected returns with the same or lower risk with the same expected return. in a well-diversified portfolio most of the risk is unsystematic ‘more than one of the above statements are false ‘Which statement about portfolio diversification is true? a proper diversification can significantly reduce or eliminate systematic risk X b. diversification reduces the portfolio’s expected return because diversification reduces a portfolio’s total risk\” © as more securities are added to a portfolio, total risk is likely to fall at a decreasing rate 1 the risk reducing benefits of diversification do not occur meaningfully until at least 100 securities are included in the portfolio ©. More than one of the above statements are true Which of the following statements are false? a, Asthe correlation coefficient between two risky securities decreases, the shape of the efficient frontier bends in towards the E(R) axis, b. The R-square indicates percentage variation in the dependent variable as a result of changes in the independent variable. In the single index market model, it indicates stock's market risk. ©) The variance of a 2-stock portfolio decreases as the correlation of the two stocks increases. When a risk-free asset is added to the Markowitz efficient frontier of risky assets, the efficient frontier becomes a straight line known as the Capital Market Line (CML) © More than one of the above statements are false ich of the following statements is false? 4 @ The slope of the SML is determined by the value of beta. Other things equal, diversification is least effective when returns are perfectly positively correlated. ¢, — For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels), the expected rate of return must be equal to the required rate of return. | ~ The slope of the CML is xs — merous. More than one of the above statements are false Which of the following statements is false? @ __Ifinvestors become less risk averse, the slope of the Security Market Line will increase. b. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) measures. ~ ©. According to the CAPM, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well- diversified portfolio. .~ 4, All portfolios on the CML are efficient regardless of investor preferences, however, depending upon their preferences and risk tolerance different investors will choose different portfolios on CML 1~ ©. More than one of the above statements are false An analyst developed the following data on stock X and the market: Return on the market = 0.1200 Covariance (Rx, Rn) = 0.0288 Standard deviation of the return on stock X (ox) = 0.1800 Standard deviation of the market return (on) = 0.2000 6288 (a) What is the beta coefficient of stock X? Answer: (b) What percentage of stock X risk is systematic? Answer: _6 47 pe ee — tym RAUSE THE FOLLOWING INFORMATION FOR THE NEXT 4 QUESTIONS. Returns on the market and Agrow’s stock during the last 3 years are shown below: { [Return | Return [fa-®e-| nhl Bn Rok (Ra Fa Year_| Agrow | Market | - | zoo | -220 | 180 |—31 |=22 | esr | yey | 961 2011 | 13.0 10.0 4 6 24 36 | 16 zoiz | 360 | 200 | 27 | 1 | 432] asé] 724 ic = 8 77% 1106 The risk-free raté is 7 percer{t) and the expected market risk-premium is 8 percent. You are considering an average- risk project whose beta is about the same as company's overall corporate beta. Agrow’s target capital structure based on market value weights calls for 60% equity and 40% debt. The marginal cost of firms debt is estimated at KIBOR plus 300 basis points based on its credit rating. KIBOR long term rate with matching maturity is about 9%. The firm's marginal tax rate is 30 percent. The project has 2 cost of PKR200 million, and it is expected to provide free cash flows of PKR 60 million per year at the end of Years | through 5. 7. What is Agrow’s corporate Beta closest to? Answer: __)- 47. Cor, ad (8 = = 569 os 2 seg ‘® pee - 1966 oo (116) =382 8. Which of the following statements is true? > Rm a 1. The correlation between Agrow’s stock return and the marke} return is negative. >< IL ‘The coefficient of determination (R-square) is less than 0.5087 = «4894 a Tistrue This true GAL dG eos call 1706) = 953 c. both are true @__ bothare false Pa ee 9. What’s the cost of each component of capital structure? Se = 24.206 ; Bs we 8 Whats the after tax cos of deb? Answer g-4/ a 567 n/ (1-3) =e Paka (QF 206) 1470) 43, b. What is Les cost oF equity based on fhe market information and your computed beta? Answi 1S Ko oT +hIC D> 187 e€ 10. What is Agrow’s WACC, assuming target capital structure weights are maintained? Answer: W-b/ waec= B4/ C4) + 19-76 C6) — 11, Bonus Qari ‘What is the project's NPV (in millions of PKR) based on above data and your WACC estimate? KR Answer: ___ 4:97" Fora wo-stock prt, a standard devon: p= |w0%;+who}+2 waweCovas D WACC = Kal -1)—2 + Ke 5 = Ku (1 -1)*Wa + Kote FACE = Kill TYE (1 -1Wa+ K. i ] | | 2, Covariancesm nF Tre B, o. |B) oa Variance m z on | a COV (gs Fg) = eo Cas Fa) = met x ne FO Sngle Index Mode R,=a,+B,Re*e)i CAPM:RequredRate ky = ry + B,(Pa - ry) E| Finance Fundamentals ~ MBA*** Name: Key Quiz # 6 ~ Fall 2018 (Dec. 10, 2018) De Total Points: 10 aa a. 1. Which of the following statements is false? Poi & Standard deviation and beta both measyre risk, but beta measures only systematic risk: while standard deviation is a measure of total risk ars in a well-diversified portfolio most of the risk is unsystematic X - risk or lower risk with the same expected return d. market risk is also referred to as the systematic risk or non-diversifiable risk ~~ e more than one of the above statements are false 2. Which statement about portfolio diversification is true? © proper diversification can significantly reduce or eliminate unsystematic 17 diversification reduces the portfolio’s expected return because diversification reduces a portfolio’s total risk X, c. as more securities are added to a portfolio, total risk is likely to fall at a increasing rate d. the risk reducing benefits of diversification do not occur meaningfully until at least 100 securities are included in the portfolio 4 ©. More than one of the above statements are true a. Which of the following statements are false? a As the correlation coefficient between two risky securities decreases, the shape of the efficient frontier bends . in towards the E(R) axis. ~~ &) The R-square indicates percentage variation in the independent variable as a result of changes in the dependent variable, > c. The variance of a 2-slock portfolio decreases as the correlation of the two stocks decreases. d. When a risk-free asset is added to the Markowitz efficient frontier of cy assets, the efficient frontier becomes a straight line known as the Capital Market Line (CML) —~ & More than one of the above statements are false 4 Which of the following statements is false? « & The slope of the SML is determined by the value of market risk premium (Ry-R)) as an indicator of average risk aversion. ® Other things equal, diversification is most effective when returns are perfectly positively correlated. X ©. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels), the expected rate of return must be equal to the required rate of return, -~ d. The slope of the CML is Gy — rar/ow. fe. More than one of the above statements are false 5. Which of the following statements is false? If investors become less risk averse, the slope of the Security Market Line will become less steep. In portfolio analysis, we often use ex post (hisforical) returns and standard deviations, despite the fact that we a b are interested in ex ante (future) measures. © According to the CAPM, investors are compensated only for assuming unsystematic risk. 4 All portfolios on the CML are efficient regardless of investor preferences, however, depending upon their preferences and risk tolerance different investors will choose different portfolios on CML © More than one of the above statements are false 6 An analyst developed the following data on stock X and the market: Return on the market 0.1200 Covariance (R,, Ra) 0.03.88 ‘Standard deviation of the return on stock X (6x) = 0.1800 Standard deviation of the market return (i) = 0.2000 (a) What is the beta coefficient of stock X? Answer: _ O° 7.5, pe 3930 = +79 D) (b) What percentage of stock X risk is systematic? Answer: _91'24 @ ——— Pi= = am “16% 12! OS eee SS. erica or oes gered fg UE CEPTS 10 ahcr portfolio afters higiepeanecsetr tars withthe semne10. Fora two-stock portfolio, the standard deviation is: oy USE THE FOLLOWING INFORMATION FOR THE NEXT 4 QUESTIONS. Returns on the market and Agrow’s stock during the last 3 years are shown below: [ etwen | Return [Trear[agrow | Market | 2010 -22.0 -24.0 | 2011 | 130 | 100 2012 | 360 | 230 4 af ‘The risk-free rate is 7 pereént, and the expected market risk-premium is 8 percent. You are considering an average- risk project whose beta is about the same as company’s overall corporate beta. Agrow’s target capital structure based on market value weights calls for 60% equity and 40% debt. The marginal cost of firm’s debt is estimated at KIBOR plus 300 basis points based on its credit rating. KIBOR long term rate with matching maturity is about 9%. The firm's marginal tax rate is 30 percent. The project has a cost of PKR200 million, and it is expected to provide free cash flows of PKR 60 million per year at the end of Years I through 5. ‘What is Agrow’s corporate Beta closest to? Answer: 1! Which of the following statements is true? L ‘The correlation between Agrow’s stock return and the market return is negative. Tl The coefficient of determination (R-square) is ess than 0.50. X (I = .4¢226y a Tis true b. Tis true Ra on c. both are true @® both are false ‘What's the cost of each component of capital structure? a, Whats the after-tax cost of debt? Answ g's 12CI- = B4/ b. What is the firm’s cost of equity baséd on the market information and your computed beta? Answer:__J6 52 / Tote 14(8/)= i652 What is Agrow's WACC, assuming target capital structure weights are maintained? Answer: _/3 +272/ e4Cu) + (6520-6) 1g 272/ wece Bonus Question: What is the project's NPV (in millions of PKR) based on above data and your WACC estimate? Answer: PRR 4+ 64082 * yoy weon*2waweCovas Covariance jm Pm Fj Ow | (eS or | Variancem om 1¢ i 2 | COV (Fs Fas) = Yu =F) Cas ~ Fa) | Single Index Model: Ry=a)+B,;Rn*ey; CAPM-RequiedRate k, = ry + B,(Py - rs) D E + K = Ku -D*Wa KAWe DE WACC = Ki(l-T)