UGBA 103
Final Exam
PRACTICE EXAM II
SOLUTION
Time: 3 hours
Name:
Student id#:
m
er as
Note: Throughout the exam, assume that there are no frictions, i.e., perfect capital
co
markets, information is immediately incorporated into stock prices, there is no spread
eH w
between borrowing and lending rates, etc. If nothing else is stated, assume that everything
o.
is in real terms. Also, if nothing else is stated, do not consider taxes. If you think that you
rs e
need to make additional assumptions, please specify these.
ou urc
Circle your final numerical answers!
.
o
aC s
vi y re
ed d
ar stu
is
Th
sh
This study source was downloaded by 100000805705997 from CourseHero.com on 11-12-2021 21:10:39 GMT -06:00
1
https://www.coursehero.com/file/9940390/PRACTICE-EXAM-II-solution/
, 1. CAPM (31 points)
The 5 parts of this problem are related.
Assume that the CAPM holds and disregard taxes. The following two scenarios
for returns over the next year are the only possible:
State of Probability Market return ADOT’s equity return
world
Boom 60% 20% 24%
Recession 40% 5% 3%
Here, company ADOT is a publicly traded company with a debt-to-asset ratio of
40%, holding risk-free debt. The one-year risk-free rate is 10%.
a) (6 points) What is the expected return of ADOT’s equity?
m
er as
co
60%*24%+40%*3%=15.6%.
eH w
b) (6 points) What is the risk-premium in the market?
o.
rs e
60%*20%+40%*5%-10%=4%
ou urc
c) (6 points) What is the covariance between ADOT’s equity returns and market
returns?
o
aC s
60%*(20%-14%)*(24%-15.6%)+40%*(5%-14%)*(3%-15.6%)=0.00756
vi y re
d) (6 points) What is ADOT’s equity beta?
ed d
CAPM => 10%+b*(14%-10%) = 15.6% => = 1.4.
ar stu
(Can also calculate using covariance/market variance formula.)
is
e) (7 points*) Another company, BDOT, claims to generate equity returns of
30% in the boom state of the world and 2% in the recession state. Can this
Th
claim be correct? Elaborate!
The claim is false. The easiest way to see this is to note that BDOT’s expected
sh
return is 18.8%, which, if it lies on the security market line, corresponds to a of
2.2. However, the implied by the covariance formula is 1.87. Thus, BDOT lies
above the security market line, which never happens in a world in which the
CAPM holds.
This study source was downloaded by 100000805705997 from CourseHero.com on 11-12-2021 21:10:39 GMT -06:00
2
https://www.coursehero.com/file/9940390/PRACTICE-EXAM-II-solution/
Final Exam
PRACTICE EXAM II
SOLUTION
Time: 3 hours
Name:
Student id#:
m
er as
Note: Throughout the exam, assume that there are no frictions, i.e., perfect capital
co
markets, information is immediately incorporated into stock prices, there is no spread
eH w
between borrowing and lending rates, etc. If nothing else is stated, assume that everything
o.
is in real terms. Also, if nothing else is stated, do not consider taxes. If you think that you
rs e
need to make additional assumptions, please specify these.
ou urc
Circle your final numerical answers!
.
o
aC s
vi y re
ed d
ar stu
is
Th
sh
This study source was downloaded by 100000805705997 from CourseHero.com on 11-12-2021 21:10:39 GMT -06:00
1
https://www.coursehero.com/file/9940390/PRACTICE-EXAM-II-solution/
, 1. CAPM (31 points)
The 5 parts of this problem are related.
Assume that the CAPM holds and disregard taxes. The following two scenarios
for returns over the next year are the only possible:
State of Probability Market return ADOT’s equity return
world
Boom 60% 20% 24%
Recession 40% 5% 3%
Here, company ADOT is a publicly traded company with a debt-to-asset ratio of
40%, holding risk-free debt. The one-year risk-free rate is 10%.
a) (6 points) What is the expected return of ADOT’s equity?
m
er as
co
60%*24%+40%*3%=15.6%.
eH w
b) (6 points) What is the risk-premium in the market?
o.
rs e
60%*20%+40%*5%-10%=4%
ou urc
c) (6 points) What is the covariance between ADOT’s equity returns and market
returns?
o
aC s
60%*(20%-14%)*(24%-15.6%)+40%*(5%-14%)*(3%-15.6%)=0.00756
vi y re
d) (6 points) What is ADOT’s equity beta?
ed d
CAPM => 10%+b*(14%-10%) = 15.6% => = 1.4.
ar stu
(Can also calculate using covariance/market variance formula.)
is
e) (7 points*) Another company, BDOT, claims to generate equity returns of
30% in the boom state of the world and 2% in the recession state. Can this
Th
claim be correct? Elaborate!
The claim is false. The easiest way to see this is to note that BDOT’s expected
sh
return is 18.8%, which, if it lies on the security market line, corresponds to a of
2.2. However, the implied by the covariance formula is 1.87. Thus, BDOT lies
above the security market line, which never happens in a world in which the
CAPM holds.
This study source was downloaded by 100000805705997 from CourseHero.com on 11-12-2021 21:10:39 GMT -06:00
2
https://www.coursehero.com/file/9940390/PRACTICE-EXAM-II-solution/
