BA 340

Midterm review questions’ solutions

1. Bond face value = $1000

Annual coupon in dollars = 0.14 * 1000 = 1400
Yield to maturity (YTM) = 12%
Semiannual periods to maturity = 20

 1 
1 − 20 
  0.12  
1 + 
140   2   1000
Bond price =  
0.12 + 20
= 1114 .70
 2    0.12 
2 1 + 
   2 
 
 

2. Limbaugh and Liddy bonds have the same risk, therefore the same required rate
of return (YTM). Liddy’s bonds are selling at par, which means that the coupon
rate is equal to the YTM which is 8%. This will be Limbaugh’s bonds YTM as
well.

Limbaugh’s bond issue:

Bond face value = $1000
Annual coupon in dollars = $50
YTM = 8%
Semiannual periods to maturity = 20

 1 
1 − 20 
  0.08  
1 + 
 50   2   1000
Bond price =  2  0 .08 + 20
= 796 .15
    0.08 
2 1 + 
   2 
 
 

3. a. Since the dividends are growing at a constant rate forever, we can use the
constant growth model to determine the value of the stock:
 D1
P0 =
r −g
None of these values are provided to us, however we can calculate them using the
information provided.

The required rate of return (r) can be calculated using CAPM:

r = 10% + 1.4 * (16% - 10%) =18.4%

The growth rate can be calculated using the historical dividends:

D0 = 3.40, D-3 = 2.70

3.40 = 2.70 * (1 + g)3; g = 7.99%

Since dividends are growing at a constant rate, D1 = D0 * (1 + g) = 3.67

Therefore, the value of the stock today is: 3.67 / (0.184 – 0.0799) = 35.25

b. The only input that will change if the beta changes is the required rate of
return.

If beta increases to 1.6, r = 10 + 1.6(16-10) = 19.6%

Then the value of the stock today is: 3.67 / (0.196 – 0.0799) = 31.61

4. In this question, dividends are growing at 6% for 2 years and 3% forever after
that. We can use a two-stage model to value the stock.

Dividends in the first stage:

D1 = $3 * (1.06) = $3.18
D2 = $3 * (1.06)2 = 3.37

The value of all remaining dividends, stage 2 dividends, (D3, D4, ….) can be
calculate at time 2 as:

P2 = D3 / r – g, and D3 = D2 * (1 + g), where g represents the growth rate in the

dividends in the second stage.

D3 = 3.37 * (1.03) = 3.47

P2 = 3.47 / (0.16-0.03) = 26.69

3.18 3.37 26 .69

Then the price today, P0 = + 2
+ = 25 .08
1.16 1.16 1.16 2

5. We need to determine whether asset B is correctly priced. We can do that by

comparing the reward-to-risk ratios of asset A (correctly priced) and B. If they are
the same, B must be correctly priced.
 R-to-R of A = 12 – 6 / 0.8 = 7.5

To calculate R-to-R of B, we must first determine what the expected return is:

Expected return of B = (37 – 30) / 30 = 23.3%

R-to-R of B = 23.3 – 6 / 1.4 = 12.36.

Since B has a R-to-R ratio greater than a correctly priced asset, it is mispriced,
and lies above the security market line (SML).

The R-to-R for A also represents the slope of the SML, which means that for each
unit of risk, for a correctly priced asset, investors require 7.5% in additional return
(beyond the risk-free rate).

So, for A that works out to 6% + 0.8*7.5% = 12%

For B, the required rate of return, if B was correctly priced, would be:
6% * 1.4*7.5% = 16.5%

So the price of B has to adjust so that the return is 16.5%:

(37 – X) / X = 16.5%, X = 31.76.

Investors will buy B (because it has a rate of return greater than that required by
the SML) until the price reaches 31.76.

6. We are provided past performance of the two stocks. We would like to have in
our portfolio stocks that outperform expectations. This means we would like to
include stocks with positive Jensen’s alphas.

Stock 1: actual return = 33-30/30 = 10%

Expected return (CAPM) = 6% + 0.5(10 – 6) = 8%

Jensen’s alpha = actual return – expected return = 10% - 8% = 2%

Stock 2: actual return = 34-30/30 = 13.33%

Expected return (CAPM) = 6% + 2.5(10 – 6) = 16%

Jensen’s alpha = actual return – expected return = 13.33% - 16% = -2.67%

Stock 1 outperformed expectations, stock 2 underperformed. We would have

preferred stock 1 in our portfolio.
7. To determine which stock is riskier, we want to compare the standard deviations
of the two stocks:
 Stock 1:

1. calculate average return:

0.12 + 0.16 + 0.25 + 0.13

= 0.165
4

2. calculate standard deviation:

( 0.12 − 0.165 ) 2 + (0.16 − 0.165 ) 2 + ( 0.25 − 0.165 ) 2 + ( 0.13 − 0.165 ) 2 = 0.059

4 −1

Stock 2:

3. calculate average return:

0.13 + 0.18 + 0.24 + 0.23

= 0.195
4

4. calculate standard deviation:

( 0.13 − 0.195 ) 2 + (0.18 − 0.195 ) 2 + ( 0.24 − 0.195 ) 2 + ( 0.23 − 0.195 ) 2 = 0.051

4 −1

8. We want to determine whether one portfolio has a higher return and a lower risk
(beta). If so, we can claim that it is superior to the other portfolio.

Portfolio 1: Expected return = 0.3*10% + 0.4*12% + 0.3*7% = 9.9%

Beta = 0.3*1.2 + 0.4*1.4 + 0.3*1 = 1.22 (mkt has a beta of 1)

Portfolio 2: Expected return = 0.45*8% + 0.35*15% + 0.2*3% = 9.45%

Beta = 0.45*1.5 + 0.35*2.2 + 0.2*0 = 1.445
(risk free asset has a beta of 1)

Portfolio 1 has a higher return and a lower risk, so it would be preferred.