Question 1 Consider the economy with only two risky assets: stock A and B. There are three possible scenarios for the economy (equal probability of each scenario) and the returns in each scenario for the market portfolio, stock A and B are the following: a) Find expected rate of return and total risk on market portfolio and on both stocks. b) Find the beta of each stock and comment of their values. (30 marks) c) Assume that the T-bill rate is 5%. Write down the CAPM equation and explain it. What does the CAPM say about the fair expected rate of return on the two stocks? (30 marks) d) Which of stock seems to be a good buy on the basis of your answers to a), b) and c)? Explain your answer. BU501? 1 JANUARY 2012 Question 1 Consider the economy with only two risky assets: stock A and B. There are three possible scenarios for the economy (equal probability of each scenario) and the returns in each scenario for the market portfolio, stock A and B are the following: a) Find expected rate of return and total risk on market portfolio and on both stocks. b) Find the beta of each stock and comment of their values. (30 marks) c) Assume that the T-bill rate is 5%. Write down the CAPM equation and explain it. What does the CAPM say about the fair expected rate of return on the two stocks? (30 marks) d) Which of stock seems to be a good buy on the basis of your answers to a), b) and c)? Explain your answer. Question 2 The RyanJet Plc is a low-cost airline company that offers cheap flights across Europe. It is all-equity financed company and it is listed on London Stock Exchange. Currently rate of return on short-term UK gilts is 4% and the expected return on FTSE 100 Index is 20%. The unlevered market beta for the RyanJet Plc equals 1.65. The company would like to offer a new connection from London Heathrow to Malaga, which would be available for five years. The mangement of the company forecasts net cash flows from this new project as follows: The entire project is financed by equity investment and it requires an initial investment of 1.5 million-. Assume the markets are perfect and there are no taxes. a) Calculate the opportunity cost of capital for this project. Explain why you can use this value to evaluate the new project of the RyanJet PIc. (25 marks) b) Calculate the NPV of the project and decide whether the RyanJet Plc should offer a new connection from London Heathrow to Malaga. (25 marks) Suppose now that the management of the RyanJet Plc considers financing 40% of the cost of the project by debt and debtholders require the rate of return of 7%. Assume there are no taxes. c) Calclate the rate of return required by the equity holders of the RyanJet.Plc. Why is it now lower/higher than the retum required by equity holders when the project was allequity financed? (25 marks) d) Calculate the new discout rate the management of the RyanJet Pic Plc should use to evaluate the project and the NPV of the project. Compare your answers with the
