30017 Corporate Finance

Lecture Slides
Session 16: Practice problems

This is a list of practice problems. We will work through the problems together in class,
probably with you solving the problem under discussion on the board. This will work best and
be most useful if you try to solve the problems on your own beforehand, as much and as far as
you manage. Some of the problems you are already familiar with, others are new.

Question content are sessions

9, 10, 11 Risk and return
12 Market events
13, 14 Risk and the cost of capital
15, Payout Policy

THIS INCLUDES
BMA 7
BMA 8
BMA 9
BMA 13
BMA 16

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Concepts to cover
Risk and returns
Diversification
Unique versus market risk
Equity Beta, Asset Beta
CAPM
Cost of capital
Payout Policy

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Q1 PORTFOLIO VARIANCE

Suppose Alto stock has a volatility of 40%, and Basso stock has a volatility of 20%. If Alto and
Basso are uncorrelated,
a. What portfolio of the two stocks has the same volatility as Mex alone?
b. What portfolio of the two stocks has the smallest possible volatility?
(Hint: Using Excel might help)

SOLUTION
Use on excel = SQRT(B6^2*$B$3^2+A6^2*$B$2^2+2*B6*A6*$B$3*$B$2*$C$2)
(x_alto, x_basso)=(40%, 60%) has the same volatility as Mex alone
(x_alto, x_basso)=(20%, 80%) minimizes portfolio variance

Vol Corr
Alto 40% 0%
Basso 20%
Portfolio
x_alto x_basso Vol
0% 100% 20.00%
10% 90% 18.44%
20% 80% 17.89%
30% 70% 18.44%
40% 60% 20.00%
50% 50% 22.36%
60% 40% 25.30%
70% 30% 28.64%
80% 20% 32.25%
90% 10% 36.06%
100% 0% 40.00%

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Q2 PORFOLIO RISK AND RETURN WITH NEGATIVE PORTFOLIO WEIGHTS

A hedge fund has created a portfolio using just two stocks. It has shorted $35,000,000 worth of
Oracle stock and has purchased $85,000,000 of Intel stock. The correlation between Oracle’s and
Intel’s returns is 0.65. The expected returns and standard deviations of the two stocks are given in
the table below:

Expected Return Standard Deviation

Oracle 12.00% 45.00%
Intel 14.50% 40.00%

a. What is the expected return of the hedge fund’s portfolio?

b. What is the standard deviation of the hedge fund’s portfolio?

SOLUTION

The total value of the portfolio is $50m = (–$35 + $85). This means that the weight on Oracle is
-70% and the weight on Intel is 170%. The expected return is -0.7*12%+1.7*14.5%=16.25%

Variance= (-0.7)2*(-0.45)2 + (1.7)2*(0.4)2 + 2(-0.7)*(1.7)*0.65*0.45*0.4=0.28

 Standard deviation=53.2%

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Q3 DIVERSIFIABLE RISK VERSUS SYSTEMATIC RISK

Identify each of the following risks as most likely to be systematic risk or diversifiable risk:
a. The risk that your main production plant is shut down due to a tornado.
b. The risk that the economy slows, decreasing demand for your firm’s products.
c. The risk that the new product you expect your R&D division to produce will not
materialize.

SOLUTION
a. diversifiable risk
b. systematic risk
c. diversifiable risk

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Q4 DIVERSIFICATION

A company has 40 million invested in long term corporate bonds. The portfolio’s expected
annual rate of return is 6%, with a standard deviation of 10%. The CFO suggests investing in an
index fund that closely tracks the S&P 500. The index fund has an expected return of 22% and
its standard deviation is 26%. The Treasury bill yield is 2%.
Can the company improve its expected rate of return without changing the risk of the portfolio?

SOLUTION

We find the portfolio weights for a combination of Treasury bills (security 1: standard deviation
= 0%) and the index fund (security 2: standard deviation = 26%) such that portfolio standard
deviation is 10%.
(10%)2 = 0 + 0 + x22 (26%)2  x2=0.3846; x1 = 0.6154
E(ret_portfolio) = (0.6154 × 0.02) + (0.3846 × 0.22) = 9.69%
So: Company can improve the expected rate of return without changing the risk of the portfolio.

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Q5 RETURN, RISK, AND SHARPE RATIO

A fund manager Duncan produced the follow percentages of rates of return. Rates of return on the
market are given for comparison. The risk freee rate is 3%.
a. Calculate the average return and standard deviation of Duncan’s mutual fund. Did the fund
do better or worse than the market?

b. Calculate the Sharpe Ratio for the Fund and the S&P

Duncan S&P 500

2015 2% 4%
2016 16% 6%
2017 25% 8%
2018 -12% 7%
2019 38% 10%

SOLUTION

Average Return Duncan (2+16+25-12+38)/5=13.8%

Average Return Market (4+6+8+7+20)/5=13.8%

SD(Duncan)=19.5 SD(Market)=2.24

Sharpe ratio = (Expected return portfolio –risk free) / the standard deviation of the portfolio

(7 − 2.924)
𝑀𝑎𝑟𝑘𝑒𝑡 = = 1.82
2.24
(13.8 − 2.924)
𝐹𝑢𝑛𝑑 = = 0.557
19.5

Fund has done worse than the market.

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Q6 OPTIMAL PORTFOLIO WEIGHTS

In addition to risk-free securities, you are currently invested in Tiger Fund, with an expected return
of 12% and a volatility (that is, standard deviation of expected returns) of 25%. The risk-free rate
of interest is 4%. Your broker suggests that you add a venture capital fund to your current
portfolio. The venture capital fund has an expected return of 20%, a volatility of 80%, and a
correlation of 0.2 with the Tigher Fund.

What is the optimal fraction of your wealth to invest in the venture capital fund in order to
maximize the Sharpe ratio of your new portfolio?

(Hint: Using Excel might help)

SOLUTION

Sharpe Ratio is maximized when 13% of wealth is invested in VC fund

Weight VC fund Expected Return

Volatility Sharpe Ratio
0 12.00% 25.00% 0.3200
0.01 12.08% 24.92% 0.3242
0.02 12.16% 24.87% 0.3281
0.03 12.24% 24.84% 0.3317
0.04 12.32% 24.84% 0.3350
0.05 12.40% 24.86% 0.3379
0.06 12.48% 24.91% 0.3405
0.07 12.56% 24.98% 0.3427
0.08 12.64% 25.08% 0.3445
0.09 12.72% 25.20% 0.3461
0.1 12.80% 25.34% 0.3472
0.11 12.88% 25.51% 0.3481
0.12 12.96% 25.70% 0.3486
0.13 13.04% 25.92% 0.3488
0.14 13.12% 26.15% 0.3487
0.15 13.20% 26.41% 0.3483
0.16 13.28% 26.69% 0.3477
0.17 13.36% 26.99% 0.3468
0.18 13.44% 27.31% 0.3457
0.19 13.52% 27.64% 0.3444
0.2 13.60% 28.00% 0.3429

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Q7 BETA

Suppose the market portfolio is equally likely to increase by 30% or decrease by 10%.
a. Calculate the beta of a firm that goes up on average by 43% when the market goes up
and goes down by 17% when the market goes down.
b. Calculate the beta of a firm that goes up on average by 18% when the market goes
down and goes down by 22% when the market goes up.
c. Calculate the beta of a firm that is expected to go up by 4% independently of the
market.

SOLUTION
D Stock 43 - (-17) 60
Beta = = = = 1.5
D Market 30 - (-10) 40
D Stock -18 - 22 -40
Beta = = = = -1
D Market 30 - (-10) 40
A firm that moves independently has no systemic risk, so beta = 0

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Q8 ESTIMATE FOR BETAS

Estimate the beta of Nike stock based on its monthly returns from 2011-2015.

Hint: You can download data from WRDS and use the slope() function in Excel.

SOLUTION

NKE 0.625 (DOUBLE CHECK WITH WRDS DATA)

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Q9 CAPM AND EXPECTED RETURNS

Suppose Alpha stock has a beta of 2.16, whereas Beta stock has a beta of 0.69. If the risk-free
interest rate is 4% and the expected return of the market portfolio is 10%, what is the expected
return of a portfolio that consists of 60% Alpha stock and 40% Beta stock, according to the
CAPM?

SOLUTION

b = (0.6) ( 2.16) + (0.4) (0.69) = 1.572

( )( )
E éë Rùû = 4 + 1.572 10 - 4 = 13.432%

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Q10 CAPM AND INVESTMENT IN INDIVIDUAL STOCKS

Your investment portfolio consists of $15,000 invested in only one stock, Microsoft. Suppose the
risk-free rate is 5%, Microsoft stock has an expected return of 12% and a volatility of 40%, and the
market portfolio has an expected return of 10% and a volatility of 18%. Under the CAPM
assumptions:

a. What alternative investment has the lowest possible volatility while having the same expected
return as Microsoft? What is the volatility of this investment?

b. What investment has the highest possible expected return while having the same volatility as
Microsoft? What is the expected return of this investment?

SOLUTION

Under the CAPM assumptions, forming a portfolio combining the market and the risk-free rate
using appropriate weights has the highest expected return of any portfolio for a given volatility and
the lowest volatility for a given expected return. In that case, if you invest a fraction x of your
wealth in the market portfolio, you can achieve an expected return of:

E(r)=5%+x*(10%-5%)

Setting this equal to 12% gives x=1.4

So the portfolio with the lowest volatility that has the same return as Microsoft has
$15,000´1.4 = $21,000 in the market portfolio, and borrows of the risk-free asset. This gives a
volatility for the investment of

( )
SD Rp = xSDéë Rmùû =1.4´18 = 25.2%

lower than Microsoft’s volatility.

A portfolio weight of x in the market portfolio such as portfolio volatility = Microsoft volatility
gives x=40/18=2.22

So the portfolio with the highest expected return that has the same volatility as Microsoft has
15000*2.2=33000 invested in the market portfolio, and borrows 18000 in the risk free asset. This
gives an expected return according to CAPM of: 5%+2.22*(10%-5%)=16%

higher than Microsoft’s expected return.

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Q11 COST OF CAPITAL

Your firm is planning to invest in an automated packaging plant. Como Industries is an all-equity
firm that specializes in this business. Suppose Como’s equity beta is 0.85, the risk-free rate is 4%,
and the market risk premium is 5%. If your firm’s project is all equity financed, estimate its cost of
capital.

SOLUTION

Project beta = 0.85 (using all equity comp)

Thus, rp = 4% + 0.85(5%) = 8.25%

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Q12 COST OF CAPITAL OF CONGLOMERATES

Lecco Enterprises is an all-equity firm with three divisions. The beverage division has an asset
beta of 0.60, expects to generate free cash flow of $50 million this year, and anticipates a 3%
perpetual growth rate. The industrial chemicals division has an asset beta of 1.20, expects to
generate free cash flow of $70 million this year, and anticipates a 2% perpetual growth rate.
Suppose the risk-free rate is 4% and the market risk premium is 5%.

a. Estimate the cost of capital of each division.

b. Estimate the value of each division.

c. Estimate Lecco’s current equity beta and cost of capital. Is this cost of capital useful for
valuing Lecco’s projects?

SOLUTION

Beverage

Ru = 4% + 0.6  5% = 7%

V = 50/(7% – 3%) = 1,250

Chemical

Ru = 4% + 1.20  5% = 10%

V = 70/(10% – 2%) = 875

Total = 1250 + 875 = $2.125 billion

Lecco Beta (portfolio)

1250/2125  0.6 + 875/2125  1.2 = 0.85

Re = 4% + 0.85  5% = 8.25%

Not useful. Individual divisions are either less risky or more risky.

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Q13 DIVIDEND, SHARE REPURCHASE, AND STOCK PRICES

Firenze Corp. has assets with a market value of $500 million, $50 million of which are cash. It has
debt of $200 million, and 10 million shares outstanding. Assume perfect capital markets.

a. What is its current stock price?

b. If Firenze Corp. distributes $50 million as a dividend, what will its share price be after the
dividend is paid?

c. If instead, Firenze Corp. distributes $50 million as a share repurchase, what will its share
price be once the shares are repurchased?

d. What will its new market debt-equity ratio be after either transaction?

SOLUTION

a. (500 – 200)/10 = 30

b. (450 – 200)/10 = 25

c. (450 – 200)/(10 – 1.667) = 30

d. 200/250 = 0.8

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Q14 DIVIDEND, STOCK REPURCHASES, AND TAXATION

Napoli Inc. will pay a constant dividend of $2 per share, per year, in perpetuity. Assume all
investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose that other
investments with equivalent risk to Napoli Inc. stock offer an after-tax return of 12%.

a. What is the price of a share of Napoli Inc. stock?

b. Assume that management makes a surprise announcement that Napoli Inc. will no longer
pay dividends but will use the cash to repurchase stock instead. What is the price of a share of
Napoli Inc. stock now?

Solution

a. P = $1.60/0.12 = $13.33

b. P = $2/0.12 = $16.67

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