PRACTICE PROBLEMS FOR THE FINAL EXAMINATION 1.

Suppose a firm just paid (at t=0) a dividend of $2. The market capitalization rate for this stock is 16% per year. The retention ratio for this firm is 60%. The dividends of the firm are expected to grow at 12% per year. Assume that the constant growth dividend discount model holds for this firm. (a) Compute P0, the price of the stock. (b) Compute , the return on the book value of the equity for this firm. (c) Compute the present value of the assets in place for this firm. (d) Compute the present value of growth opportunities for this firm. 2. A project requires investment of $100 million at t=0, and generates cash flows of $10 million, $20 million, $40 million, $60 million, and $80 million at t=1, 2, 3, 4, and 5 respectively. (a) Work out the payback period assuming the cash flows occur strictly at the points of time specified. (b) Work out the payback period assuming the fourth cash flow is uniformly spread between t=3 and t=4. 3. Suppose the current price of XYZ stock is $60, and an investor believes that its value next period (at t=1) will be either $54 or $72 with equal probability. Suppose further that investment in one-period T-Bill returns 5%. (a) Work out the expected price of the stock. (b) Work out the expected return on the stock. (c) Work out the variance and the standard deviation of the stock price at t=1. (d) Work out the variance and the standard deviation of the return on the stock. (e) Indicate whether an investor who prefers investing in this stock to investing in the T-Bill is risk-averse. 4. Suppose the covariance between returns on two stocks is 0.4. The standard deviation of returns on the first stock is 20%, while the variance of returns on the second stock is 4. Work out the correlation between returns on two stocks. 5. Suppose the variance of returns on a portfolio is 0.146025. The portfolio is made up of three stocks. The fraction invested in the first stock is 10%. The dollar amount invested in the second stock is twice that invested in the third stock. The standard deviation of returns on the first two stock is 15% and 30% respectively. The returns on any one stock are uncorrelated with the returns on the other two (12 = 13 = 23 =0). Work out the standard deviation of the returns on the third stock. 6. The expected return on a stock is 16% per year while the risk free rate is 1% per year. Assuming that the market portfolio is expected to return 11% per year, work out the beta of the stock. 7. Suppose the standard deviation of returns on two stocks is 0.18 and 0.225 respectively. The correlation of the returns on the two stocks is 0.09. Work out the dollar amount you would invest in the first stock in a risk-minimizing portfolio of $90 million.