Part 1: Material Covered Since the Midterm Exam
1. Definitions. Define the following terms in 2-3 sentences. Then explain why the term is important to know.
a. market portfolio
b. asset beta
2. Short Computations. (Retrieve the Practice Final Exam excel file from the Moodle site.)
a. On 1 September 2017 Generic Pharmaceuticals (GP) sells new Aa-rated, $1,000 par-value, 10-year, 4% coupon bonds which pay interest semiannually starting exactly six months later. The bonds sell for a price of $1,000. On 2 September 2017 Fed Chairman Janet Yellen takes actions which raise the market’s required return on Aa-rated bonds to 6% per year. At what price do GP bonds sell on 2 September 2017?
b. Intel has just paid an annual dividend on its common stock of $0.63 per share. Analysts expect Intel’s annual dividend to grow about 8% per year for the next four years before settling down to an annual growth rate of 3% per year into perpetuity. If stockholders require a 9% annual return on Intel common, what is the value of a share of Intel today? (Round to 4 decimal places in your intermediate calculations.)
. A financial analyst is thinking of investing in a three-stock portfolio composed of Stocks A, B and C. The analyst has estimated state-dependent returns for each stock (RA,S, RB,S and RC,S respectively) for each of two states (S) as well as the probability of each state (PS). The analyst wants to invest the available cash as follows: 50% Stock A, 30% Stock B and 20% Stock C. (Set your calculator to show 6 decimal places.)
i) Compute the standard deviation of the return on Stock A, σA.
ii) Compute the covariance between the returns on Stock A and Stock B, σAB.
iii) Compute the standard deviation of the return on portfolio P, σP , composed of 50% Stock A, 30% Stock B and 20% Stock C,
Data on the expected returns ( E(Ri) ), standard deviations of return ( σi ), and betas (βi ) for Assets E,G, H, the market portfolio, and the risk-free asset appear in the table. The table also shows the coefficients of correlation between the assets’ returns and the return on the market portfolio ( ρiM ). Compute the missing numbers
vi) What is the beta of a portfolio having $200 of Asset E, $400 of Asset G and $400 of Asset H?
vii) Is Asset G correctly priced according to the capital asset pricing model? Why or why not? If not, is Asset G over-priced or under-priced? What will be Asset G’s expected return when correctly priced?
e. New Kids Motor Company (NKMC) went public in March 2013. Management is now considering a major expansion of the company’s factories. To complete its analysis management needs to know NKMC’s cost of equity capital. At present the risk-free return, measured by the current yield on 1-year Treasury bills, is 1% (0.01); the historical market risk premium, RM – RF, is 7% (0.07). Start-of-month prices for the S&P500, an oft-used stand-in for the market portfolio, and for NKMC stock from 01 April 2013 thru 01 April 2015 appear in the spreadsheet which accompanies this exam. Compute a cost of equity for NKMC.
3. Objective Agree / Disagree Questions. Put an “A” in the blank for “Agree” or a “D” for “Disagree.”
a. If the Federal Reserve wants to raise interest rates it sells US Treasury securities.
Questions b, c and d to Assets V and S. E(RV ) > E(RS) and σV > σS. Portfolios formed from V and S have non-negative portfolio weights, i.e., 0 ≤ XV , XS ≤ 1.
b. The expected return on a portfolio formed from V and S cannot exceed E(RV ) or be less than E(RS) ; i.e., E(RS) ≤ E(RP ) ≤ E(RV ).
c. The standard deviation of the return on a portfolio formed from V and S cannot exceed σV or be less than σS ; i.e., σS ≤ σP ≤ σV .
d. The less highly correlated are the state-dependent return on Assets V and S, the less straight is the feasible set of portfolios formed from these two assets.
e. The management of Apple observes in the “Risk Factors” section of its most recent 10K: “The Company’s future performance depends, in part, on support from third-party software developers.” (Apparently Apple has hired outside developers to write apps for Apple.) This risk factor is an example of a systematic risk.
Questions f, g and h refer to Portfolio S, invested in 5 risky capital assets, and Portfolio L, invested in 50 risky capital assets. E(RS) and E(RL) are the expected returns on Portfolios S and L, respectively; σ2S and σ2L are the variances of the returns on Portfolio S and L, respectively.
f. σ2S is probably larger than σ2L.
g. The unsystematic risks of the assets in Portfolio S probably influence σ2S more than the unsystematic risks of the assets in Portfolio L influence σ2L.
h. E(RS) is probably larger than E(RL).
i. As the number of risky assets in a portfolio increases, the variance of the portfolio’s return (σ2P) depends more on the covariances of the assets’ returns than on the variances of the assets’ returns.
j. The amount of risk any one capital asset contributes to σ2M, the risk of the market portfolio, is best represented by the variance of the return on that asset, namely σ2i.
k. All the portfolios along the capital market line are composed of the same two assets however the portfolio weights of the two assets differ.
l. Unless all risky capital assets have the same reward-to-risk ratios, the capital market is out of equilibrium.
Parts m. – r. pertain to the following information about Firms A – G. Firms A, B, C and G operate in Industry 1; Firm D operates in Industry 2; and Firms E and F operate in both Industry 1 and Industry 2. Firms' debt-to-equity ratios (B/S) are shown. None of the firms is taxed. The managements of the seven firms are evaluating capital budgeting projects. Projects in the same industry as the firm are replacement or expansion projects; projects in a different industry than the firm are non-expansion or non-replacement projects. All accepted projects will be financed using the same B/S ratio as the firm’s current B/S ratio.