UT FIN 357 - ReviewTest2withsolutions (9 pages)

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ReviewTest2withsolutions



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ReviewTest2withsolutions

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Pages:
9
School:
University of Texas at Austin
Course:
Fin 357 - Business Finance

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REVIW TEST 2 with Solutions by M L Poloskey These are some questions I wrote for another text that you can use for practice Note Not all topics in our text are covered here 1 Using the following information from Capstone Corporation what price would CAPM predict that this company s stock will trade for 1 year from today if you assume a risk free rate of 3 and a market risk premium of 8 Beta 65 Current Price 64 61 Estimated Forward Annual Dividend 1 92 Solution Using CAPM we find E RCapstone Rrf Capstone E Rm Rrf 0 03 65 0 08 E RCapstone 082 or 8 2 Then using the formula for an asset s return during a period P P0 CF1 P 64 61 1 92 RT 1 0 082 1 P1 67 99 P0 64 61 2 How are covariance and correlation different Solution Both covariance and correlation measure the co movements of returns The covariance is the expected product of the deviations of two returns from their means To compute the correlation the covariance is divided by the standard deviation of each return This scales the result so it is always between 1 and 1 and makes it easier to interpret 3 Calculate the beta of this portfolio and use the capital asset pricing model CAPM to determine its expected rate of return The market expected rate of return is 15 and the riskfree rate is 7 Stock A B C Solution Investment 200 000 300 000 500 000 Beta 1 50 65 1 25 Portfolio Beta p N w i 1 A B C Total i i 200 000 300 000 500 000 1 000 000 20 30 50 100 p 20 1 50 30 65 50 1 25 1 12 E RPortfolio Rrf Portfolio E RM Rrf E RPortfolio 07 1 12 15 07 1596 or 15 96 4 What would you recommend to an investor who is considering an investment which according to its beta plots below the security market line SML Solution Recommend the investor does not invest An investment that plots below the SML has high risk relative to return CAPM would predict an investment with that beta should have a higher return 5 Why does an investor want a diversified portfolio Can an investor eliminate all risk Solution An investor of a diversified portfolio reduces risk by investing in two or more assets whose values do not always move in the same direction at the same time Through diversification the investor can eliminate unsystematic or unique risk but still faces systematic or market risk 6 Testco Corp is considering adding a new product line The cost of the factory and equipment to produce this product is 1 780 000 and the company expects increased cash flows from the sale of this product to be 450 000 for each of the next eight years If the company uses a discount rate of 12 percent what is the net present



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