BMMF5103 – SUGGESTED ANSWERS:
(i). E(r) = .05(-.5) + .10(-.15) + .2(.05) + .3(.15) + .2(.25) + .15(.40) = .125 = 12.5% (ii). Var =.05(-.50 - .125)2 + .1(-.15 - .125)2 + .2(.05 - .125)2 + .3(.15 - .125)2 + .2(.25 - .125)2 + .15(.40 .125)2 = .0428 Stddev = (.0428)1/2 = .2069
(iii) C.V. = .2069/.125 = 1.6552
First find the portfolio’s beta:
15% = 6% + (6%)bp
9% = 6%bp
bp = 1.5.
Let bc be the beta of the company for which she works. The portfolio’s beta is a weighted average of the individual betas of the stocks in the portfolio. Therefore, 1.5 = ($5,000/$20,000)1.2 + ($15,000/$20,000)bC.
1.5 = 0.3 + 0.75bc
1.2 = 0.75bc
bc = 1.6.
The unsystematic risk is the company-specific risk whereas the systematic risk is the market-specific risk. The former can be diversifiable away through the formation of portfolios comprising of assets that are negatively correlated with one another. The later continues to remain in the system and its presence is acknowledged by beta. The sources of unsystematic risk include the firm'
s financing decisions and the firm'
s operations. A
higher beta increases the required rate of return.
Equity = 0.25($6,000) = $1,500.
Current ROE =
New ROE =
= 0.20 = 20%.
∆ROE = 20% - 16% = 4%.
This question requires working backwards through the income statement from net income to sales. The income statement will look like this:
$500,000/(1 - 0.6)
$100,000 + $400,000
$240,000/(1 - 0.4)
Liquid assets are those that can be sold quickly with little or no loss in value. A firm that has sufficient liquidity will be less likely to experience financial distress. Most income statements contain some noncash items, so these must be accounted for when calculating cash flows. More importantly, however, since GAAP is used to create income statements, revenues and expenses are booked when they accrue, not when their corresponding cash flows occur.
a. Agency costs arise in a corporation as a result of principal-agent problems. For example; managers may not act in the best interests of the shareholders while making decisions. Hence the shareholders incur monitoring costs that are called agency costs. It also arises as result of informational asymmetry between managers and other stakeholders of a firm. Agency costs tend to reduce the value of a firm. b. The three principal forms of business organization are sole proprietorship, partnership, and corporation. The advantages of the first two include the ease and low cost of formation. The advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) setting up a corporation and filing required state and federal reports, which are complex and time-consuming. c. The three forms, or levels, of market efficiency are: weak-form efficiency, semistrongform efficiency, and strong-form efficiency. The weak form of the EMH states that all information contained in past stock price movements is fully reflected in current market prices. The semistrong form of the EMH states that current market prices reflect all 2
publicly available information. The strong form of the EMH states that current market prices reflect all pertinent information, whether publicly available or privately held. d. The...
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