FINA 3332 EXAM 3 FULL REVISION NOTES
WITH CAPITAL BUDGETING AND INVESTMENT
DECISION CONCEPTS
◉ One portfolio has three securities. Stock A accounts for 50% with
beta =1, stock B accounts for 10% with beta 50% lower than market
beta and stock C accounts for the rest with beta 20% higher than
market average.
Answer: Stock B = 50% lower than market average beta = 1×0.5=0.5
Stock C= 20% higher than market average beta= 1.2×1= 1.2
Stock A weight= 50%, beta =1, stock B weight =10%
Beta=0.5 and stock c = 40% and beta = 1.2
Systematic risk of the portfolio = weighted average beta of the
portfolio =
0.5×1+0.1×0.5+0.4×1.2 = 1.03
◉ Suppose that beta for a given stock is same as market beta. Risk-
free rate is 2%.
a. What is the expected return for this stock if expected market
return is 10%?
b. What is the expected return for this stock if market risk premium
is 10%?
,Answer: now that market beta is equal to 1. Therefore, the beta of
the stock = βS = 1
Risk-free rate = RF = 2%
Part a
Expected market return = RM = 10%
The expected return of the stock can be calculated using CAPM
E[RS] = RF + βS*(RM-RF) = 2% + 1*(10%-2%) = 10%
Answer a -> 10%
Part b
Market risk premium = RM-RF = 10%
The expected return of the stock can be calculated using CAPM
E[RS] = RF + βS*(RM-RF) = 2% + 1*10% = 12%
Answer b -> 12%
◉ You are a financial manager of a firm and are asked to assess the
cost of capital of your firm.
You know that
Your firm is going to pay dividend $3 per share
The current stock price is $60 per share
Firm beta is 10% lower than market average
,Constant growth rate is 3%
Expected market return is 10% and risk free rate is 2%
There is totally 10 million of outstanding shares of stocks, and for
each dollar equity, firm issued $1.5 debt
Cost of borrowing/issuing bond is 5%
Corporate tax rate 30%
Answer: Dividend $3 here is [D1 or D0]? D1
What is the cost of equity (common stock) using dividend growth
model?
3$ x 3% = .09 + $3 = 3.09
3. = .0515 + .03 (growth rate) = .08
risk_free_rate = 0.02 # Risk-free rate (2% converted to decimal)
expected_market_return = 0.10 # Expected market return (10%
converted to decimal)
market_beta = 1 # Market beta is typically assumed to be 1
firm_beta = market_beta - (0.10 * market_beta) # Firm beta is 10%
lower than market average
# Calculating the cost of equity using CAPM
cost_of_equity_capm = risk_free_rate + firm_beta *
(expected_market_return - risk_free_rate)
Market Beta = 1 - (.1 * 1)
, .02 + .9 * (.1 - .02) = .092
◉ What is total value of the firm
Answer: current_stock_price = 60 # Current stock price in dollars
total_outstanding_shares = 10000000 # Total number of outstanding
shares debt_to_equity_ratio = 1.5 # For each dollar equity, $1.5 in
debt
market_value_of_equity = current_stock_price *
total_outstanding_shares
market_value_of_debt = market_value_of_equity *
debt_to_equity_ratio
total_value_of_firm = market_value_of_equity + market_value_of_debt
market_value_of_equity, market_value_of_debt, total_value_of_firm
The market value of equity is $600,000,000 (calculated as $60 per
share times 10 million shares).
The market value of debt is $900,000,000, calculated based on the
debt-to-equity ratio of 1.5.
Therefore, the total value of the firm (equity plus debt) is
$1,500,000,000
WITH CAPITAL BUDGETING AND INVESTMENT
DECISION CONCEPTS
◉ One portfolio has three securities. Stock A accounts for 50% with
beta =1, stock B accounts for 10% with beta 50% lower than market
beta and stock C accounts for the rest with beta 20% higher than
market average.
Answer: Stock B = 50% lower than market average beta = 1×0.5=0.5
Stock C= 20% higher than market average beta= 1.2×1= 1.2
Stock A weight= 50%, beta =1, stock B weight =10%
Beta=0.5 and stock c = 40% and beta = 1.2
Systematic risk of the portfolio = weighted average beta of the
portfolio =
0.5×1+0.1×0.5+0.4×1.2 = 1.03
◉ Suppose that beta for a given stock is same as market beta. Risk-
free rate is 2%.
a. What is the expected return for this stock if expected market
return is 10%?
b. What is the expected return for this stock if market risk premium
is 10%?
,Answer: now that market beta is equal to 1. Therefore, the beta of
the stock = βS = 1
Risk-free rate = RF = 2%
Part a
Expected market return = RM = 10%
The expected return of the stock can be calculated using CAPM
E[RS] = RF + βS*(RM-RF) = 2% + 1*(10%-2%) = 10%
Answer a -> 10%
Part b
Market risk premium = RM-RF = 10%
The expected return of the stock can be calculated using CAPM
E[RS] = RF + βS*(RM-RF) = 2% + 1*10% = 12%
Answer b -> 12%
◉ You are a financial manager of a firm and are asked to assess the
cost of capital of your firm.
You know that
Your firm is going to pay dividend $3 per share
The current stock price is $60 per share
Firm beta is 10% lower than market average
,Constant growth rate is 3%
Expected market return is 10% and risk free rate is 2%
There is totally 10 million of outstanding shares of stocks, and for
each dollar equity, firm issued $1.5 debt
Cost of borrowing/issuing bond is 5%
Corporate tax rate 30%
Answer: Dividend $3 here is [D1 or D0]? D1
What is the cost of equity (common stock) using dividend growth
model?
3$ x 3% = .09 + $3 = 3.09
3. = .0515 + .03 (growth rate) = .08
risk_free_rate = 0.02 # Risk-free rate (2% converted to decimal)
expected_market_return = 0.10 # Expected market return (10%
converted to decimal)
market_beta = 1 # Market beta is typically assumed to be 1
firm_beta = market_beta - (0.10 * market_beta) # Firm beta is 10%
lower than market average
# Calculating the cost of equity using CAPM
cost_of_equity_capm = risk_free_rate + firm_beta *
(expected_market_return - risk_free_rate)
Market Beta = 1 - (.1 * 1)
, .02 + .9 * (.1 - .02) = .092
◉ What is total value of the firm
Answer: current_stock_price = 60 # Current stock price in dollars
total_outstanding_shares = 10000000 # Total number of outstanding
shares debt_to_equity_ratio = 1.5 # For each dollar equity, $1.5 in
debt
market_value_of_equity = current_stock_price *
total_outstanding_shares
market_value_of_debt = market_value_of_equity *
debt_to_equity_ratio
total_value_of_firm = market_value_of_equity + market_value_of_debt
market_value_of_equity, market_value_of_debt, total_value_of_firm
The market value of equity is $600,000,000 (calculated as $60 per
share times 10 million shares).
The market value of debt is $900,000,000, calculated based on the
debt-to-equity ratio of 1.5.
Therefore, the total value of the firm (equity plus debt) is
$1,500,000,000
