BA 340 Midterm 2 Solutions

Multiple Choice

  1. A
  2. C
  3. D
  4. C
  5. D (60 + 1.45 – 53) / 53 = 15.9%
  6. B
  7. B
  8. A
  9. D
  10. E

Short Answer

1. E(r) for: A: 0.15* 0.6 + 0.05 * 0.4 = 11%

B: 0.08 * 0.6 + 0.20 * 0.4 = 12.8%

Risk free asset: 4%

Weights in:A: 4000/10000 = 0.4, B: 4000/10000 = 0.4;

Riskfree asset: 2000/10000 =0.2

E(r) for portfolio: 0.4 * 11% + 0.4 * 12.8% + 0.2 * 4% = 10.32%

Value of portfolio today = $10,000

Expected value in one year = 10000 * 1 + 0.1032 = $11,032

To calculate standard deviation, we need to calculate the expected return of the portfolio in each state

E(r) for portfolio in: Boom:0.4 * 15% + 0.4 * 8% + 0.2 * 4% = 10%

Bust: 0.4 * 5% + 0.4 * 20% + 0.2 * 4% = 10.8%

Standard deviation:

=

2. a. D1 = 1.1, D2 = 1.21, D3 = 1.331

D4 = D3 * (1+g) = 1.331 * (1+0.04) = 1.384

P3 = 1.384 / (0.1 – 0.04) = 23.07

P0 =

b. If an additional dividend of $3 is paid in year 2, then the price will change by the present value of that dividend:

3 / 1.12 = $2.48

3. Bond L is selling at par, therefore the price of the bond is $1000 (face value).

Bond M price:

  1. To determine whether investors were satisfied over the past year in IBM and HP stock, we need to determine whether the return the stocks generated was greater than what was expected by investors, i.e., Jensen’s alpha.

Jensen’s alpha = actual return – expected return (based on CAPM)

HP: actual return: (32.96 + 0.32 – 22.29) / 22.29 = 49.3%

Expected return: 4.8% + 2.05 * (5.9% - 4.8%) = 7.06%

Jensen’s alpha = 49.3 – 7.06 = 42.24% --- Investors very satisfied.

IBM: actual return: (80.41 + 1.20 – 75.68) / 75.68 = 7.84%

Expected return: 4.8% + 1.58 * (5.9% - 4.8%) = 6.54%

Jensen’s alpha = 7.84 – 6.54 = 1.3% --- Investors satisfied.

  1. Using CAPM, we can determine what investors’ expected return is for WVVI:

5% + 1.17 * (10%-5%) = 10.85%

However, if the analyst is believed, the return over the next year will be:

(8 – 6.68) / 6.68 = 19.76%

Investors will therefore get a return greater than they expect by investing in WVVI. Therefore, investors would buy the stock when the announcement is made. Buying the stock would drive up the price. The price would increase until the return for the next investor that buys the stock is what is expected by CAPM.

( 8 – X) / X = 10.85% …solving for X: $7.22

The stock would plot above the SML when it is priced at 6.68. As investors buy the stock, it will return to the SML when it hits a price of $7.22.