Tutorial no. 10 Business Finance (MGT 337Y)

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					                      Tutorial no. 10
               Business Finance (MGT 337Y)
                         Mirela Predescu-Vasvari
                       Rotman School of Management
                              November 22, 2002


Problem 11.1
  a. Real GNP was lower than anticipated. Since returns are positively related to the
     level of GNP returns should fall based on this factor.
     Inflation was exactly the amount anticipated. Since there was no surprise in this
     announcement, it will not affect Lewis-Striden returns.
     Interest rates are higher than anticipated. Since returns are negatively related to
     interest rates, the higher than expected rate is bad news. Returns should fall due
     to interest rates.
     The president’s death is bad news. Although the president was expected to re-
     tire, his retirement would not be effective for six months. During that period he
     would still contribute to the firm. His untimely death mean that those contribu-
     tions would not be made. Since he was generally considered an asset to the firm,
     his death will cause returns to fall.
     The poor research results are also bad news. Since Lewis-Striden must continue
     to test the drug as early as expected. The delay will affect expected future earn-
     ings, and thus will dampen returns now.
     The research breakthrough is positive news for Lewis Striden. Since it was un-
     expected, it will cause returns to rise.
     The competitor’s announcement is also unexpected, but it is not a welcome sur-
     prise. This announcement will lower the returns on Lewis Striden.

  b. Systematic risk is risk that cannot be diversified away through formation of a
     portfolio. Generally, systematic risk factors are those factors that affect a large
     number of firms in the market. Note those factors do not have to equally affect
     the firms. The systematic factors in the list are real GNP, inflation and interest
     rates.

  c. Unsystematic risk is the type of risk that can be diversified away through port-
     folio formation. Unsystematic risk factors are specific to the firm or industry.

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       Surprises in these factors will affect the returns of the firm in which you are in-
       terested, but they will have no effect on the returns of firms in a different industry
       and perhaps little effect on other firms in the same industry. For Lewis-Striden,
       the unsystematic risk factors are the president’s ability to contribute to the firm,
       the research results and the competitor.

Problem 11.3
  a. Systematic Risk= 2.04(.048 − .035) − 1.90(.152 − .140) = 0.00372 = 0.372%

  b. Unsystematic Return= −0.030(55 − 57) − 1.40(.027 − .027) = 0.06 = 6%

  c. Total Return= 0.09 + 0.00372 + 0.06 = 0.15372 = 15.372%

Problem 11.4
  a. Stock A:
     RA = RA + βA (Rm − Rm ) + εA
     RA = 10.5% + 1.2(Rm − 14.2%) + εA
     Stock B:
     RB = RB + βB (Rm − Rm ) + εB
     RB = 13% + 0.98(Rm − 14.2%) + εB
     Stock C:
     RC = RC + βC (Rm − Rm ) + εC
     RC = 15.7% + 1.37(Rm − 14.2%) + εC


  b. RP = 0.40RA + 0.25RB + 0.35RC
     = 0.40[10.5% + 1.2(Rm − 14.2%) + εA ]
     + 0.25[13% + 0.98(Rm − 14.2%) + εB ]
     + 0.35[15.7% + 1.37(Rm − 14.2%) + εC ]
     = 12.945% + 1.2045(Rm − 14.2%) + 0.40εA + 0.25εB + 0.35εC

  c.    (i) RA = 10.5% + 1.2(12% − 14.2%) = 7.86%
            RB = 13% + 0.98(12% − 14.2%) = 10.84%
            RC = 15.7% + 1.37(12% − 14.2%) = 12.69%
        (ii) RP = 12.945% + 1.2045(12% − 14.2%) = 10.2951%

Problem 11.7
  a. V ar(Rj ) = βi2 V ar(Rm ) + V ar(εi )
     σA = 0.52 (100) + 500 = 525
      2

     σB = 1.62 (100) + 100 = 356
      2

     σC = 12 (100) + 2500 = 2600
      2
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b.    (i) As N → ∞, V ar(εi )/N → 0
           2
          σA = 0.52 (100) = 25
           2
          σB = 1.62 (100) = 256
           2
          σC = 12 (100) = 100
     (ii) The easiest way to see which portfolio would not be held is to draw the
          security market line for these securities. Security C will not be held because
          point C lies below the line through A and B.
     (iii) Everyone would want to sell the portfolio C, but no one would want to buy
           it. Competition will bid down the price of C until its expected return is
           on the security market line. The algebraic characterization of that line is
           E(Ri ) = − 0.09 + ×β 0.4
                       1.1      1.1