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Managerial Finance B6022

Midterm Exam
Module 4 Assignment 2
Lydia Ross

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Managerial Finance B6022
Midterm Exam
Lydia Ross

Problems:

1. Expected Rate of Return = ∑i n Priri

=2 (-5%) +.4(10%)+.5(30%)

= .18

2. Expected Rate of Return = ∑i n Priri

=.3(30%)+.2(10%)+.5(-2%)
=.1 or 10%

3. Beta Before = 1.5

Beta of \$50,000 = 3
Combined = (1.5 + 3)/2 = 2.25

4. Required Rate of Return = risk free rate + (market rate of return - risk free rate)*
Beta of the stock
rRF = 5%, rM = 12%, ß = 1.5
= .155

5. Required Rate of Return = risk free rate + (market rate of return - risk free rate)*
Beta of the stock
rRF = 4%, rM = 5%, ß = 2.0
=.06

6. Stock E has the greater relevant risk of 60% as opposed to Stock D relevant risk
of 18%.

7. Required Rate of Return = risk free rate + (market rate of return - risk free rate)*
Beta of the stock
. 16 = n + (.10 – n) * 1.8
= (.03)

8.
rRF = 3%, rM = 10%
Weight =
r = rRF + Stock/Total
Stock ß (rM -rRF)b Stock
\$
400,000.00 1.5 0.135 0.4
\$
500,000.00 2.0 0.17 0.5
\$ 4.0 0.31 0.1

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Managerial Finance B6022
Midterm Exam
Lydia Ross

100,000.00

Answer: rp = .135(.4) + .17(.5) + .31(.1) = .

17 or 17%

10.

Weight =
Stock/Total
Stock r Stock
\$
10,000.00 30% 0.1
\$
50,000.00 16% 0.5
\$
40,000.00 20% 0.4

rp= (.3*.1) + (.16 *.5) +(.4 *.2) = .

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8-24
a. “Like other low-risk investments, such as savings accounts and certificates of
deposit (CDs), T-Bills often earn relatively low interest; unlike with those
other options, however, interest earned by a T-Bill is not subject to state or
local taxes, although it is subject to federal income tax. Also, they are issued
in denominations of \$100 and up to a maximum of \$5 million in government
securities which may be purchased at a single auction. They are fully backed
by the credit of the U.S. government and thus are considered essentially risk-
free (Practical Money, 2011)”. “High tech’s returns move with, hence are
positively correlated with, the economy, because the firm’s sales, and hence
profits, will generally experience the same type of ups and downs as the
economy. If the economy is booming, so will high tech. On the other hand,
collections is considered by many investors to be a hedge against both bad
times and high inflation, so if the stock market crashes, investors in this stock
should do relatively well. Stocks such as collections are thus negatively
correlated with (move counter to) the economy (Umdrive Memphis, 2011)”.

17.4%.

r t-bills= 0.1(8%) + 0.2(8%) + 0.4(8%) + 0.2(8%) + 0.1(8%) = 8%

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Managerial Finance B6022
Midterm Exam
Lydia Ross

σ T-bills = [(8- 8)2(0.1) + (8 - 8)2(0.2) + (8 - 8)2(0.4)

+ (8 - 8)2(0.2) + (8 - 8)2(0.1)]½

σ T-bills =0%

= [ 68.95 + 33.59 + 1.211 +27.56 + 47.26] ½

=√280.761

σ Collections =13.36%

= [1.44 + 113.28 +18.49 +194.68 +26.24] ½

σ USRubber =18.82%

σ M = 15.3%

“The standard deviation is often used by investors to measure the risk of a

stock or a stock portfolio. The basic idea is that the standard deviation is a
measure of volatility: the more a stock's returns vary from the stock's

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Managerial Finance B6022
Midterm Exam
Lydia Ross

average return, the more volatile the stock (David M. Lane)”. High tech is
the most risky investment.

e. Since we are only investing \$50,000, we are investing half or .5 of the

\$100,000. We are investing in High Tech and Collections.
For A Recession: rp = 0.5(-22%) + 0.5(28%) = 3%.
Below Average: rBA = .5(-2) +.5(14.7) = 6.35%
Average: rA = .5(20) +.5(0) = 10%
Above Average: rAA = .5(35) + .5(-10) = 12.5%
Boom: rB = .5(50) +.5(-20) = 15%
The expected return on the two portfolio is weight * the expected return or
The expected return = 0.5(17.4%) + 0.5(1.7%) = 9.6%

σ p = [(3.0 - 9.6)2(0.1) + (6.4 - 9.6)2(0.2) + (10.0 - 9.6)2(0.4) + (12.5 -

9.6)2(0.2) + (15.0 - 9.6)2(0.1)]½ = 3.3%.

CVp = 3.3%/9.6% = 0.34.

f. The portfolio of the two stand alone stocks is significantly better than the
stand alone stock by itself. These two stocks are negatively correlated and
will offset each other in the event one is not doing well. This is a good
example of diversification.

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Managerial Finance B6022
Midterm Exam
Lydia Ross

Portfolio

Single Stock

R=
Risk are reduced by adding stock to the portfolio. Therefore a portfolio of
16 %
stock is less risky than a single stock.

g. It is better to have a well diversified portfolio because it reduces risk. If a

risky stock is in the portfolio, other stock not as risky as the risky stock offset
it. You can still earn a premium on the other stocks in the portfolio.
However, the entire stock market riskiness impacts all portfolio’s and these
risk cannot be offset.

h. “The measure of an asset's risk in relation to the market (for example, the
S&P500) or to an alternative benchmark or factors. Roughly speaking, a
security with a beta of 1.5, will have move, on average, 1.5 times the market
return. [More precisely, that stock's excess return (over and above a short-
term money market rate) is expected to move 1.5 times the market excess
return).] According to asset pricing theory, beta represents the type of risk,
systematic risk, that cannot be diversified away. When using beta, there are
a number of issues that you need to be aware of: (1) betas may change
through time; (2) betas may be different depending on the direction of the
market (i.e. betas may be greater for down moves in the market rather than
up moves); (3) the estimated beta will be biased if the security does not
frequently trade; (4) the beta is not necessarily a complete measure of risk
(you may need multiple betas). Also, note that the beta is a measure of
comovement, not volatility.
Return It is possible for a security to have a zero beta
on Stock
and higher volatility than the market. The expected returns are related to
High Tech
(%)
each alternative’s market
40 risk--that is, the higher the alternative’s rate of
(slope = beta = 1.30)Market
return the higher its beta. Also, note that t-bills have zero risk. We do not
(slope = beta
yet have enough information to choose among the= various
1.0) alternatives
(Farlex, 2011)”.
20

T-Bills

(slope = beta = 0)
Return on the
-20 20 40
Market

(%) 6

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Managerial Finance B6022
Midterm Exam
Lydia Ross

ri = rRF + (rM –rRF)ßi.

i. Merrill finch has estimated the risk-free rate to be krf = 8%. Further, our
estimate of rm = rm is 15 percent. The required rates of return for the
alternatives are as follows:

Collections: 8% + (15% - 8%)-0.87 = 1.91%.

EXPECTED REQUIRED
RETURN RETURN
SECURITY (r^) (r) CONDITION
HIGH TECH 17.4% 17.1% UNDERVALUED: r^> r
MARKET 15.0 15.0 FAIRLY VALUED (MARKET EQUILIBRIUM)
U.S. RUBBER 13.8 14.2 OVERVALUED: r > r>
T-BILLS 8.0 8.0 FAIRLY VALUED
COLLECTIONS 1.7 1.9 OVERVALUED: r > r^

The t-bills and the market portfolio promise a fair return, high tech is a
good deal because its expected return is above its required return, and

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Managerial Finance B6022
Midterm Exam
Lydia Ross

collections and US rubber have expected returns below their required

returns. Collections required rate of return is below the risk-free rate.
Basically, this means that collections is a valuable security to rational,
well-diversified investors.

= 0.215

If inflation expectations increase by 3 percentage points, with no change

in risk aversion, then the entire SML is shifted upward. When investors’
risk aversion increases, the sml is rotated upward about the y-intercept (rrf).
Rrf remains at 8 percent, but now rm increases to 18 percent, so the market
risk premium increases to 10 percent. The required rate of return will rise
sharply on high-risk (high-beta) stocks, but not much on low-beta securities.

9-1 NPV is a way to decide whether or not to invest in a project by looking at the
projected cash inflows and outflows. Based on the analysis below, the
project is a go.

X : Amount received per year = 20,000

n : Number of years = 6

NPV = X * [(1+r)^n - 1]/[r * (1+r)^n]

6-1
= 20,000*[(1 +10%) ]/[10% * (1 +10%)6

=3221.02/.1771561

=\$18,181.82

9-2 =NPV(14%,-75000,50000,40000) (Computed on Excel spreadsheet using

financial formulas)

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Managerial Finance B6022
Midterm Exam
Lydia Ross

IRR = 20% using excel spreadsheet

9-4 The projects should be accepted if they deliver a 14% rate of return. (Excel

-23000 -48000 -36000

7900 0 -10000
7900 0 0
7900 0 0
7900 81000 75000
IRA = 14% 14% 14%

9-5 =IRR(G15:G18) (Excel Spreadsheet)

= 14%

9-6 =IRR(B30:B37) = 11%, Exit should not purchase the project. Exit’s rate of
return is 12%.

9-7 PB = 5 + (450000/120000)

PB = 8.75 yrs.

9-8 PBt = 4 + (10000/15000)

= 4.67 yrs

PBNT = 4 + (10000/12100)

=4.83 yrs

9-9 =MIRR(E31:E33,12,1.5) (Excel Spreadsheet)

= 46%

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Managerial Finance B6022
Midterm Exam
Lydia Ross

P Q
-15000 -37500
4500 11100
4500 11100
4500 11100
4500 11100
4500 11100
NPV=(\$3,375.37) (\$8,050.14) (\$3,377.43)
IRR= 15% 15%
MIRR= 16.6 12.46

9-14

If the projects are independent, Project P should be selected according

to the MIRR and the net present value. If they are mutually exclusive, according to
the NPV it is almost the same and either project would be as good as P is by itself.
According to the IRR, the projects are the same and either can be chosen.

References

Beta. (n.d.). Retrieved 3 28, 2011, from Financial Dictionary: http://financial-

dictionary.thefreedictionary.com/Beta+coefficient

Calculate Net Present Value. (n.d.). Retrieved 3 28, 2011, from EHow:
http://www.ehow.com/how_2187130_calculate-net-present-value-
npv.html#ixzz1Hwa6OHIL

Econ 101. (n.d.). Retrieved 4 28, 2011, from Practical Money Skills:
http://www.practicalmoneyskills.com/foreducators/econ101/20090904_tbills.php

HyperStat. (n.d.). Retrieved 3 28, 2011, from David M. Lane:

http://davidmlane.com/hyperstat/A40397.html

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Managerial Finance B6022
Midterm Exam
Lydia Ross

Teaching. (n.d.). Retrieved 3 27, 2011, from Umdrive Memphis:

https://umdrive.memphis.edu/cjiang/www/teaching/fir3410/.../im05.doc

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