ECON3420 Homework 4

Due by 11:59 pm on Dec 5th, 2022

1. Suppose an investment bank has $900 billion in assets under management and a
leverage ratio (Assets / Equity) of 30 to 1. If the bank earns (annually) a 6%
return on its assets and pays 3% interest on its debt and the tax rate is 20%, what
is the (annual) return-on-equity?

2. Consider a one-factor Arbitrage Pricing Theory model. There are two well-diversified
portfolios: A and B. Portfolio A’s expected return is 25 percent and its beta is
0.75; Portfolio B’s expected return is 12 percent and its beta is 0.25. What is the
risk-free rate in the model?

3. A company is considering whether to start a large project. It will cost the company
$20 billion in year 0, and generate profits of $10 billion and $13 billion in years 1
and 2, respectively. The risk-free rates in years 0 and 1 are the same, 2 percent,
and the expected market returns in years 0 and 1 are also the same, 6 percent.
The company’s β is a constant 0.75. Use the discretely compound rate to calculate
results.

a) Given the above information, should the company start the project?

b) Suppose the company has an option to pay a maintenance $5 billion in year 1

to raise its profit by $5.26 in year 2. Should the company take the option in year
1?

c) Following the setting of part b. Suppose the monetary authority raises the risk-
free in year 1 to 3 percent, should the company start the project and/or take the
maintenance option in year 1 ?

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4. Discuss whether each of following statements is true or false and WHY.

a. Suppose all the assumptions of the Capital Asset Pricing Model hold, we can
show that a well-diversified portfolio’s return rp and its βp satisfies

E(rp ) − rf = βp (E(rm ) − rf ),

where rm is the market portfolio’s return and rf is the risk-free rate.

b. Suppose there is no arbitrage in the financial market, we can show that a

particular stock’s return ri and its βi satisfies

E(ri ) − rf = βi (E(rm ) − rf ),

where rm is the market portfolio’s return and rf is the risk-free rate.

c. Consider the equity carve-outs example (i.e., 3Com and Palm case), one of
the reasons why the law of one price fails is the difficulty of purchasing the child
company Palm’s shares.

d. The Siamese Twin Companies of Royal Dutch and Shell is an example of risk-
free arbitrage.