Corporate Finance, Autumn 2016

Tutorial 5

The problem sets must be submitted via Canvas by 18:30 on Monday, 26th September. Answers
will be posted on Canvas later on the same day.

Question 1:
1) The common stock of Leaning Tower of Pita, Inc., a restaurant chain, will generate the
following payoffs to investors next year:

Dividend Stock Price

Boom $5.00 $195
Normal Economy 2.00 100
Recession 0 0

The company goes out of business if a recession hits. Calculate the expected rate of return and
standard deviation of return to Leaning Tower of Pita shareholders. Assume for simplicity that the
three possible states of the economy are equally likely. The stock is selling today for $90.

Question 2:
2) Sassafras Oil is staking all its remaining capital on wildcat exploration off the Cote d’Huile.
There is a 10% chance of discovering a field with reserves of 50 million barrels. If it finds oil,
it will immediately sell the reserves to Big Oil, at a price depending on the state of the
economy. Thus, the possible payoffs are as follows:

Value of Reserves, Value of Reserves, Value of Dryholes

per Barrel 50 Million Barrels
Boom $4.00 $200,000,000 0
Normal economy $5.00 $250,000,000 0
Recession $6.00 $300,000,000 0

Is Sassafras Oil a risky investment for a diversified investor in the stock market --- compared, say, to
the stock of Leaning Tower of Pita in the exercise above? Explain. (Note that the answer to this
question is of a qualitative and not quantitative nature).

Question 3:

Suppose Mrs. Qureshi can invest all her savings in shares of Ihser plc., or all her savings in Resque
plc. Alternatively she could diversify her investment between these two. There are two possible states
of the economy, growth or recession, and the returns on Ihser and Resque depend on which state will
occur.

State of the Prob. of state Ihser return (%) Resque return (%)
Economy occurring
Boom 0.7 30 15

Recession 0.3 -10 20

a) Calculate expected return, variance and standard deviation for each share
b) Calculate the expected return, variance and standard deviation for the following diversifying
allocations of Mrs. Qureshi’s savings:

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Corporate Finance, Autumn 2016

a. 50% in Ihser, 50% in Resque;

b. 11% in Ihser, 89% in Resque.

c) Explain the relationship between risk reduction and the correlation between individual financial
security returns.

Question 4:

Here are some historical data on return and risk characteristics of Boeing and Polaroid.

Boeing Polaroid

Expected return 16.24% 18.08%

Yearly standard deviation of return (%) 21 26

Assume the standard deviation of the return on the market was 15%.

(a) The correlation coefficient of Boeing’s return versus Polaroid’s is 0.37. What is the standard
deviation of a portfolio invested half in Boeing and half in Polaroid?
(b) What is the standard deviation of a portfolio invested one-third in Boeing, one-third in
Polaroid, and one-third in Treasury bills? (Note: Treasury bills are risk-free assets.)

Question 5 (based on the information given in question 4):

Position Boeing and Polaroid on a "mean-variance" graph, and trace the portfolio frontier assuming
that that there is no risk-free asset and that the correlation between the two stocks is (1) ρ = 0,
(2) ρ = -1, (3) ρ = 1

Question 6:

“The expected return from a portfolio of securities is the average of the expected returns of the
individual securities that make up the portfolio, weighted by the value of the securities in the
portfolio”
“The expected standard deviation of returns from a portfolio of securities is the average of the
standard deviations of returns of the individual securities that make up the portfolio, weighted by the
value of the securities in the portfolio”

Are these statements correct?

2 out of 2