PROBLEM SET 2: DUE 10/15/2020

Chapter 7:

1.What is the expected return on asset A if it has a beta of 0.6, the expected market
return is 15%, and the risk-free rate is 6%?
=.6(15%-6%)+6%
=.6(9%)+6%
=11.4%

2. What is the portfolio beta if 60% of your money is invested in the market portfolio, and
the remainder is invested in a risk-free asset?
Beta = beta m * .60 + beta rf (.40)
Beta rf = 0
Beta = .60

3.Suppose you have the following information:

Security Return Standard Deviation Beta
A 16% 20% 1.2
B 12% 25% 0.8
T-bills 4% ??? ???
1. What is the portfolio expected return and portfolio beta if you have 35% in asset
A, 45% in asset B, and 20% in T-bills?
Beta = .35 * 1.2 = .42
= .45 * .8 = .36
= .20 * 0 = 0
Beta = .78
Portfolio expected return = .35 *.16 = .056
= .45* .12 = .054
= .20 * .04. = .008
Portfolio expected return = 11.8%
B. What is the portfolio expected return if you have 140% invested in asset A,
and the remainder in T-bills via borrowing at the risk-free rate?
= 1.4*16 + (-.4)*4
 = 22.4 – 1.6
= 20.8%
4. Which of the following statements about the security market line are true?

● The SML provides a benchmark for evaluating expected investment

performance
● The SML leads all investors to invest in the same portfolio of risky assets
● The SML is a graphic representation of the relationship between expected
return and beta
● Properly valued assets plot exactly on the SML

5. Karen Kay, a portfolio manager at Collins Asset Management, is using the

CAPM to make recommendations to her clients. Her research department has
developed the information shown below:

Forecasted Standard Beta

Return Deviation

Stock X 14% 36% 0.8

Stock Y 17 25 1.5

Market 14 15 1.0
Index

Risk-free 5 ??? ???

rate

1. Calculate the expected return and alpha for each stock.

E (r x) = 5% + .8(14%-5%) Alpha = 14% - 12.2% = 1.8%
= 5% + .8(9%)
= 5% + 7.2%
= 12.2%
E (r y) = 5% + 1.5(14%-5%) Alpha = 14% - 18.5% = -4.5%
= 5% + 1.5(9%)
= 5% + 13.5%
= 18.5%
2. Which stock would be more appropriate for an investor who wants to
1. Add this stock to a well-diversified portfolio
Stock X because it has a positive alpha and lower beta
2. Hold this stock as a single-stock portfolio
The stock with the higher Sharpe ratio since it has a lower standard deviation,
as well as higher rate of return.

6.The market price of a security is $40. Its expected rate of return is 13%. The risk-free
rate is 7%, and the market risk premium is 8%. What will the market price of the security
be if its beta doubles (and all other variables remain unchanged)? Assume the dividend
will be constant in perpetuity.
If beta doubles then so does the risk premium
Risk premium = (13% - 7%) = 6%, double it and you get 12%
New discount rate = 12% + 7% = 19%

Price = dividend/discount rate

Old price => 40 = x/.13 ; x = $5.20
New price => x = 5.20/.19; x = $27.37

Increasing beta will decrease stock price by 31.58%

7. Are the following statements true or false? Explain.

● Stocks with a beta of zero offer a zero expected rate of return. False, the return
is equal to rf + beta*(RP), if beta is equal to 0 then the risk-free rate would still remain.
Therefore, the return would be equal to the risk-free rate.
● The CAPM implies that investors require a higher expected rate of return to hold highly
volatile securities. FALSE. Investors only care for market/undiversifiable risks.
● You can construct a portfolio with a beta of 0.75 by holding 0.75 of assets in T-bills and
the rest in the market portfolio. False. Your portfolio should be invested 75% in the
market portfolio and 25% in T-bills.

8.If the simple CAPM is valid, which of the following situations is possible? Consider each
situation separately.

Expected return Standard Deviation

 Risk-free asset 10% 0%

Market 18 24

Portfolio A 16 12

This is not possible. The variability of the market portfolio is 0.33% and the variability of
Portfolio A is 0.5. Portfolio A will not provide a better tradeoff than the market portfolio as
it has a much higher variability.

b).

Expected return Standard Deviation

Risk-free asset 10% 0%

Market 18 24

Portfolio A 16 22

This is possible as the variability for portfolio A is 0.27% and the variability for
the market portfolio is 0.33%. Portfolio A will provide a better tradeoff than the
market portfolio as it has a lower variability.

Chapter 13:
[Chapter-end problems: 3, 5, 7, 9, 11, 13, 15, and 17]
3. If a security is underpriced (i.e., intrinsic value > price), then what is the relationship between
its market capitalization rate and its expected rate of return?
If a security is underpriced then the expected rate of return is greater than the market
capitalization rate.

5. Jand, Inc., currently pays a dividend of $1.22, which is expected to grow indefinitely at 5%. If
the current value of Jand’s shares based on the constant-growth dividend discount model is
$32.03, what is the required rate of return?
=[[1.22 * (1 + .05)]/32.03] + .05
= 8.99%

7. Tri-coat Paints has a current market value of $41 per share with earnings of $3.64. What is the
present value of its growth opportunities (PVGO) if the required return is 9%?
= 41 – (3.64/.09)
= 41 – 40.44
= $0.56

9. The market capitalization rate for Admiral Motors Company is 8%. Its expected ROE is 10%
and its expected EPS is $5. If the firm’s plowback ratio is 60%, what will be its P/E ratio?
Growth rate = .10 * .60
= .06
Price = (5 * .40)/(.08-.06)
= 2/.02
= 100
P/E = 100/5
= 20

11. Sisters Corp expects to earn $6 per share next year. The firm’s ROE is 15% and its plowback
ratio is 60%. If the firm’s market capitalization rate is 10%, what is the present value of its
growth opportunities?
Growth = .15 * .60
= .09
Price (constant growth) = (6 * .40)/(.10-.09)
= 2.4/.01
= $240
Price (no growth) = 6/.10 = $60
PVGO = $240 - $60 = $180

13. FinCorp’s free cash flow to the firm is reported as $205 million. The firm’s interest expense
is $22 million. Assume the tax rate is 35% and the net debt of the firm increases by $3 million.
What is the market value of equity if the FCFE is projected to grow at 3% indefinitely and the
cost of equity is 12%?
FCFE = 205,000,000 - 22,000,000(1-.35) + 3,000,000
 = 205,000,000 - 14,300,000 + 3,000,000
= 193,700,000

Market value of equity = 193,700,000/(.12-.03)

= $2,152,222,222.22

15. The risk-free rate of return is 5%, the required rate of return on the market is 10%, and High-
Flyer stock has a beta coefficient of 1.5. If the dividend per share expected during the coming
year, D1, is $2.50 and g = 4%, at what price should a share sell?
Required rate of return =.05 + 1.5(.10-.05)
= .05 + .075
= 0.125
Stock price = 2.50/(.125-.04)
= 2.50/.085
= $29.41
17. a. Computer stocks currently provide an expected rate of return of 16%. MBI, a large
computer company, will pay a year-end dividend of $2 per share. If the stock is selling at $50 per
share, what must be the market’s expectation of the growth rate of MBI dividends?
50 = 2/(.16-g)
50(.16-g) = 2
8 – 50g = 2
-50g = -6
g = -6/-50
g = .12 = 12%

Solve for g

b. If dividend growth forecasts for MBI are revised downward to 5% per year, what will
happen to the price of MBI stock?
Po = 2/(.16-.05)
= 2/.11
=$18.18

c. What (qualitatively) will happen to the company’s price–earnings ratio?

The price-earnings ratio will decrease since the price decreases towards the negative
forecast of dividend growth.