Problem Set #2 Due before class on Tuesday, October 5

Chapter 9 Problems

1. Spatial Navigation Inc. just reported earnings of $2 million and plans on retaining 25
percent of its earnings. The company has 500,000 shares outstanding. Its return on equity
is expected to remain constant at 12%, and the appropriate discount rate on the stock is
10%. Assume that a dividend was just paid.

a. What is the firm’s growth rate of earnings?

b. What is the price of the stock?

2. MZ Corp has just reported earnings of $20 million, and it plans to retain 75 percent of its
earnings. The company has 1.25 million shares of common stock outstanding. The stock
is selling for $60 and the company’s ROE is 12% and is expected to stay at that level in
the future.

a. What is the discount rate on the stock?

b. What is the NPVGO for this company?

3. Star Corp has 5 million shares outstanding and no growth opportunities. It just paid a
dividend of $6 per share and has a market value of $62.5 million.

a. What is the discount rate on Star’s stock?

b. The firm has an opportunity to invest in a new project. The project requires an
additional investment of $1.2 million today and will generate additional earnings
in the next 10 years. The first earnings amount of $0.3 million will begin one year
from now and grow at 4% each year thereafter (until year 10). Assuming no
taxes, calculate the NPV of the new project.

c. What will the stock price be if the firm undertakes the new project?

Chapter 10 Problems

4. Returns on Goode company stocks were as follows:

2015: 17.80%
2016: 2.94%
2017: 23.43%
2018: 29.13%
2019: -1.17%

What was the 5-year holding period return for Goode company’s stocks over this period?

5. You purchased 2,000 shares of a stock a year ago. The stock paid you a $2 dividend per
share. If you purchased the stock at $83 per share and are now selling it for a price of $82
per share.
a. What is your capital gain?
b. What is your total dollar return?
c. What is your percentage return?
 6. You are evaluating the returns of a stock over the last 6 years. The Returns for the stock
are given by:

201
-4.52%
4
201
14.73%
5
201
2.35%
6
201
19.17%
7
201
4.03%
8
201
9 9.86%

a. What was the mean (i.e., arithmetic average) return over this period?
b. What was the variance and standard deviation of returns over this period?
c. What was the geometric average return over this period?

Chapter 11 Problems

7. Your insurance agent offers you a fire damage policy for $200. The policy covers your
house that is worth $150,000. Suppose the probability of a fire (that destroys the house
completely) during the year is 0.0001 and consider the insurance policy as a security.
a. What is the expected holding-period return (HPR)?
b. What is the standard deviation of its HPR?

8. Consider the return behavior of the following two stocks:

State of Economy Probability of State Return on Stock A Return on Stock B

Recession .25 -4.0% 7%
Normal .60 7.2% 8.2%
Boom .15 13.4% 9.4%

a. Calculate the expected return on each stock.

b. Calculate the standard deviation of the return on each stock.
c. Calculate the covariance and correlation of returns between the two stocks.

9. Refer to the data above

a. Suppose an investor formed a portfolio by placing $1,000 in Stock A and $1,000
in Stock B, calculate the expected return and standard deviation of this portfolio.
b. Suppose an investor formed a portfolio by placing $1,500 in Stock A and $500 in
Stock B, calculate the expected return and standard deviation of this portfolio.

10. You invest 80% of your funds in Stock A and the rest in Stock B. The following table
summarizes the returns on Stocks A and B.
 SECURITY EXPECTED STANDARD
RETURN DEVIATION
STOCK A 5% 10%
STOCK B 10% 20%

a. What is the expected return of the portfolio?

b. What is the variance of the portfolio assuming the correlation between the returns
of A and the returns of B is +1.0?
c. What is the variance of the portfolio assuming the correlation between the returns
of A and the returns of B is +0.5?

11. You are constructing an investment portfolio. You can invest in American Airlines,
Southwest Airlines, and T-bills. The expected return on American is 7% with a standard
deviation of 12%. The expected return on Southwest is 13% with standard deviation of
24%. The correlation coefficient between American and Southwest is 0.2. The T-bill rate is
2%.

a. Initially you mistakenly assume that you can only invest in one of the airlines and T-
bills. Which airline should you invest in? (Hint: Think about slopes of lines in risk-
return space)

b. Now you realize you can invest in both airlines and you want to construct a portfolio
by investing solely in the two airlines and yielding an expected return of 10%.
i. What are the portfolio weights on the two airlines?

ii. What is the standard deviation of this portfolio?

12. An industrial firm has a beta of 1.4. Based on historical data you estimate the market risk
premium to be 8.5% and the current risk-free rate is 5%. Using the CAPM, what is the
expected return on the stock for this industrial firm?

13. You estimate that the expected return on a retailing firm’s stock is 15%. If the expected
return for this stock is described by the CAPM, what is its beta? Use the market risk
premium and risk-free rate from the previous example.

14. Are the following data consistent with the CAPM model? Explain.

a. Portfolio Expected Return Beta

b. Risk-free securities .10 0
c. Market Portfolio .18 1.0
d. Security A .22 1.5

15. Are the following data consistent with the CAPM?

Portfolio Expected Return Standard Deviation

Risk-free 0.10 0
Market 0.18 0.24
Portfolio A 0.16 0.12