Option 1

Question 1: Portfolio Risk

Golden Eagle invests 60% of their funds in stock I and the balance in stock J. The standard deviation of returns on I is 10%, and on J it is 20%. Calculate the variance of portfolio returns, assuming

60% of the money is invested in Stock I

40% of the money is invested in stock J

1. The correlation between the returns is 1.0

(0.60^2 * 0.10^2) + (0.40^2 * 0.20^2) + 2 (0.60 * 0.40 * 1.0 * 0.10 * 0.20)

= 0.0036 + 0.0064 + 2 (0.0048)= 0.0196

• The correlation is .5.

(0.60^2 * 0.10^2) + (0.40^2 * 0.20^2) + 2 (0.60 * 0.40 * 0.5 * 0.10 *  0.20)

=0.0036 + 0.0064 + 2(0.0024)= 0.0148

• The correlation is 0.

Portfolio Variance = 60%^2 * 10%^2 + 40%^2 * 20%^2 + 2*60%*40%*10%*20%*0

Portfolio Variance = 0.01 or 1%

Question 2: Certainty Equivalents

A project has the following forecasted cash flows:

Cash Flows (\$ Thousands)

The estimated project beta is 1.5. The market return r m is 16%, and the risk-free rate rf is 7%.

1. Estimate the opportunity cost of capital and the project’s PV (using the same rate to discount each cash flow).

Opportunity Cost of Capital = rf + (rm – rf) x Beta

7% + (16% – 7%) x 1.5

7% + 13.5%

Opportunity Cost of Capital = 20.5%

Project PV = [(C0 + C1) /(1 + r) ^1] + [C2/(1 + r) ^2] + [C3/(1 + r) ^3]

[(-100 + 40) /(1 + 0.205) ^1] + [60/(1 + 0.205) ^2] + [50/(1 +.0.205) ^3]

60/(1.205^1) + 60/(1.205^2) + 50/(1.205^3)

Project PV = \$3.09

• What are the certainty-equivalent cash flows in each year?
• What is the ratio of the certainty-equivalent cash flow to the expected cash flow in each year?
• Explain why this ratio declines.

Question 3: Measuring Risk

The following table shows estimates of the risk of two well-known Canadian stocks:

1. What proportion of each stock’s risk was market risk, and what proportion was specific risk?
2. What is the variance of TDM Bank? What is the specific variance?
3. What is the confidence interval on LLW’s beta?
4. If the CAPM is correct, what is the expected return on TDM Bank? Assume a risk-free interest rate of 5% and an expected market return of 12%.
5. Suppose that next year the market provides a zero return. Knowing this, what return would you expect from TDM Bank?

Question 4: Company Cost of Capital

You are given the following information for GFF Financial:

Long-term debt outstanding: \$300,000

Current yield to maturity (rdebt ): 8%

Number of shares of common stock: 10,000

Price per share: \$50

Book value per share: \$25

Expected rate of return on stock (requity): 15%

Calculate GFF Financial’s company cost of capital. Ignore taxes.

References

Project Management Institute. (2017). The PMI Guide to Business Analysis. Project Management Institute.

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