FINANCIAL MANAGEMENT 19

FINANCIAL MARKETS
STOCK VALUATION, BOND VALUATION AND PORTFOLIO MANAGEMENT

I. Explain the following concepts concretely and concisely in no less than 5 sentences.
1. Capital Asset Pricing Model (CAPM) (10 points)
2. Efficient Market Hypothesis (10 points)
3. Diversification

II. Problems.
1. Assume that the risk-free rate is 5 percent, and that the market risk premium is 7 percent. If a
stock has a required rate of return of 13.75 percent, what is its beta?
13.75% = 5% + (7%)b
8.75% = 7%b
b = 1.25.
2. A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free
rate is 5 percent. What is the market risk premium?
12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043% ≈ 6.30%.
3. Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5
percent rate of inflation in the future. The real rate of return is equal to 3 percent and the
market risk premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of return has
averaged 15 percent over the last 5 years.
IP: 5.00%
Real rate: 3.00%
RPM: 5.00%
Beta: 2.00
 3% + 5% + 2.0(5%) = 18%
4. The Jones Company has decided to undertake a large project. Consequently, there is a need for
additional funds. The financial manager plans to issue preferred stock with a perpetual annual
dividend of $5 per share and a par value of $30. If the required return on this stock is currently
20 percent, what should be the stock’s market value? Vp = Dp/kp = $5/0.20 = $25
5. Thames Inc.’s most recent dividend was $2.40 per share (D0 = $2.40). The dividend is expected
to grow at a rate of 6 percent per year. The risk-free rate is 5 percent and the return on the
market is 9 percent. If the company’s beta is 1.3, what is the price of the stock today? The
required rate of return on the stock: 5% + (9% - 5%)1.3 = 10.2%. D1 = $2.40 × 1.06 = $2.544. The
price of the stock today is $2.544/(0.102 - 0.06) = $60.57. 7
6. A stock is expected to pay a dividend of $0.50 at the end of the year (i.e., D1 = 0.50). Its dividend
is expected to grow at a constant rate of 7 percent a year, and the stock has a required return of
12 percent. What is the expected price of the stock four years from today?
𝐷1 $0.50
The price today, 𝑃0 = 𝑟−𝑔
= .12− .07
= $10.00
Since this is a constant growth stock, its price will grow at the same rate as dividends. So, P 4 =
P0(1.07)4 = $10.00(1.07)4 = $13.108 ≈ $13.11. Or
𝐷5 𝐷1 (1.07)4 $0.50(1.07)4
𝑃4 = = = = $13.108 ≈ $13.11
𝑟 − 𝑔 . 12 − .07 . 12 − .07
7. The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a
constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10
percent forever. Klein’s required rate of return on equity is 12 percent. What is the current price
of Klein’s common stock? $50.16

8. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for
1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate
is expected to be a constant 7 percent thereafter. The required rate of return on equity is 10
percent. What is the current stock price? $67.47
9. A bond has an annual 8 percent coupon rate, a maturity of 10 years, a face value of $1,000, and
makes semiannual payments. If the price is $934.96, what is the annual nominal yield to
maturity on the bond? 9%
𝑥 −10(2)
. 08 1 − (1 + 2) 𝑥 −10(2)
$934.96 = $1,000 ( ) ( 𝑥 ) + $1,000 (1 + )
2 2
2
𝑥 = 9%

. 08 ($1,000 − $934.96)
1,000 ( 2 ) +
10(2)
= 4.5008408
. 40($1,000) + .60($934.96)

4.5008408(2) = 9.0016816%
10. A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your
nominal annual required rate of return is 12 percent with quarterly compounding, how much
should you be willing to pay for this bond? $1,115.57
.12 −10(4)
1− (1+
4
) .12 −10(4)
$35 ( .12 ) + $1,000 (1 + 4
) = $1,115.57
4

For numbers 11 to 15
Assume that your uncle holds just one stock, East Coast Bank (ECB), which he thinks has very little
risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be
even lower if he were more diversified. You obtain the following returns data for West Coast Bank
(WCB). Both banks have had less variability than most other stocks over the past 5 years. Measured
by the standard deviation of returns, by how much would your uncle's risk have been reduced if he
had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample
standard deviation formula.)

Year ECB WCB

2008 40.00% 40.00%
2009 -10.00% 15.00%
2010 35.00% -5.00%
 2011 -5.00% -10.00%
2012 15.00% 35.00%

Average return = 15.00% 15.00%

Standard deviation = 22.64% 22.64%

Compute the following:

11. Covariance of ECB and WCB (covECB, WCB) r x sx x sy = 0.018125
12. Correlation coefficient of ECB and WCB (rECB,WCB) r = 0.353658536
13. Expected return of the portfolio (E(r)PTF) .60(𝑥̅ ) + .40(𝑦̅)= 15%
2
14. Standard deviation of the portfolio (sd PTF) = √𝑠𝑑𝑃𝑇𝐹 = 0.188015956 = 18.80%
2 2 2 2 2
15. Variance of the portfolio (sd PTF) = .60 (sx ) + .40 (sx ) + 2(.6)(.4)( r x sx x sy) = 0.03535 = 35.35%