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UGBA 103 PRACTICE EXAM II - solution
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UGBA 103Final Exam
PRACTICE EXAM II
SOLUTION
Time: 3 hours
Name:
Student id#:
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Note: Throughout the exam, assume that there are no frictions, i.e., perfect capital
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markets, information is immediately incorporated into stock prices, there is no spread
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between borrowing and lending rates, etc. If nothing else is stated, assume that everything
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is in real terms. Also, if nothing else is stated, do not consider taxes. If you think that you
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need to make additional assumptions, please specify these.
ou urc
Circle your final numerical answers!
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aC s
vi y re
ed d
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is
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, 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?
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60%*24%+40%*3%=15.6%.
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b) (6 points) What is the risk-premium in the market?
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60%*20%+40%*5%-10%=4%
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c) (6 points) What is the covariance between ADOT’s equity returns and market
returns?
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aC s
60%*(20%-14%)*(24%-15.6%)+40%*(5%-14%)*(3%-15.6%)=0.00756
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d) (6 points) What is ADOT’s equity beta?
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CAPM => 10%+b*(14%-10%) = 15.6% => = 1.4.
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(Can also calculate using covariance/market variance formula.)
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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
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claim be correct? Elaborate!
The claim is false. The easiest way to see this is to note that BDOT’s expected
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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/
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