Financial Economics HEC, Paris

Problem Set 3

Exercise 1

Consider two stocks, ABC and XYZ. The rates of return of the two stocks next year, rABC and rXYZ,
depend on economic conditions, which are equally likely to be good, OK, or bad.
rABC and rXYZ are expected to be as follows:

Economic conditions rABC rXYZ

Good 30.86% 75.42%
OK 18.96% 11.10%
Bad -4.83% -41.53%

a) Compute the expected rate of return and variance of returns of the two stocks. Compute the correlation
coefficient between the rates of return of the two stocks.
b) Suppose you want to invest $10,000 in portfolio P, which contains 50% of stock ABC and 50% of
stock XYZ. Compute the expected rate of return and the variance of return of this portfolio.
c) Suppose you can also invest in the stocks of utility companies. Each utility firm has an
expected rate of return of 10% and a standard deviation of return of 5%. There is no
correlation between the rates of return of two such firms. Assume you invest an equal amount in 15 such
utility companies. Calculate the expected return and variance of return of this portfolio. Would increasing
the number of utility companies in your portfolio affect the expected return and variance of the portfolio?
Interpret your result.
d) Now assume you invest a fraction α of your wealth in the portfolio of part (c), and the rest of your
wealth in portfolio P of part (b). Assume that the correlation between the rate of return of any utility firm
and the rate of return of ABC or XYZ is zero. How should you choose α if you want to minimize the
variance of your wealth?

Exercise 2

The probability distribution for security X is:

Probability 0.1 0.2 0.4 0.2 0.1

Rate of return 0.6 0.4 0.3 0.2 -1

Furthermore, there exists another risky security, Y, whose rate of return is linked to that of X by the
following relation: rY = 0.06 + 0.2 rX.

a) What is the expected rate of return of securities X and Y? What is the standard deviation of return of
securities X and Y? What is the correlation of the returns of securities X and Y?
b) Suppose there is a risk-free security with a rate of return equal to 0.06. Which profitable operation can
you realize and under what conditions? Be sure to describe in detail the operation you have in mind.

Exercise 3 (Capital Budgeting) [Do not forget material that we have already learnt!]
Your firm spent $2 million in R&D to conceive a new generation computer. The computer will be built in
a new factory. The cost of this factory is $10 million paid today. In five years from now, the computer
will be outdated and the factory will be shut down. The resale value of the factory and its equipment is
expected to be $11 million. For this project, the financial planning division of the firm forecasts the
following Income Statement (in million dollars) for the first year of operations:

Sales revenues 50
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Cost of goods sold 35
Depreciation of the factory 2
General Selling and Administrative Expenses 3
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Operating Income 10

The factory will be in activity until the end of year 5, hence from date t=1 until date t=5 included. Sales
revenues are expected to grow at a rate of 10% per year while the cost of goods sold and the other
expenses are expected to remain constant.
The working capital requirement at date t=0 is $10 million (*). It is then expected to grow at a rate of 3%
per year.
The tax rate is 40% (taxes are paid at the end of each year).
The rate of return on a one-year Treasury bill is 6%.
Compute the net cash flow of the project for each year of operation.
The chief Financial Officer decides to use a discount rate of 6% to compute the NPV of the project. Does
she decide to undertake the project or not?
Is the choice of 6% discount rate a good idea (discuss)?
(*) The Working Capital requirement is defined for the purpose of this exercise as:
Inventories + Receivables - Accounts Payable. You can make the following assumptions:
The working capital requirement of $10 million is created at date t=0 so that at the end of the first year 1
(t=1) working capital will be of $10.3 million.
At the end of year 5 (t= 5), working capital is $10*1.035 million and will be liquidated in year 6 (i.e. at
the end of the 6th year (t=6), working capital is 0).