RSM333mid09 SOLUTION

# RSM333mid09 SOLUTION - UNIVERSITY OF TORONTO Joseph L...

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Unformatted text preview: UNIVERSITY OF TORONTO Joseph L. Rotman School of Management Feb. 24, 2009 Buti/Farooqi RSM333 MID-TERM EXAMINATION Florence/Konukoglu SOLUTIONS 1. (a) IRR A :- \$10,000 + \$1,200 / IRR A = 0 ⇒ IRR A = 0 . 12 , IRR B :- \$8,000 + \$1,600 / IRR B = 0 ⇒ IRR B = 0 . 2 , IRR C :- \$8,000 + \$1,600 / IRR C = 0 ⇒ IRR C = 0 . 2 . (b) β A = Cov[ R A ,R m ] / Var[ R m ] = ( ρ Am σ A ) /σ m = (0 . 065)(0 . 55) / . 05 = 0 . 715 . Similarly, β B = ( ρ Bm σ B ) /σ m = (1)(0 . 175) / . 05 = 3 . 5 . β C = ( ρ Cm σ C ) /σ m = (0 . 2)(0 . 25) / . 05 = 1 . 0.5 1 1.5 2 2.5 3 3.5 4 0.05 0.1 0.15 0.2 0.25 β ExpectedReturn A B C (c) The security market line is given by E [ R i ] = R F + β i ( E [ R m ]- R F ) = 0 . 1 + β i (0 . 14- . 10) . 1 E [ R A ] = 0 . 1 + 0 . 715 × . 04 = 0 . 1286 > . 12 ⇒ Reject project A. E [ R B ] = 0 . 1 + 3 . 5 × . 04 = 0 . 24 > . 2 ⇒ Reject project B. E [ R C ] = 0 . 1 + 1 × . 04 = 0 . 14 < . 2 ⇒ Accept project C. (d) See the figure above. (e) No, you still accept only project C . The discount rate of the project should be determined by the systematic risk of the project but not by the WACC of the company. 2. (a) The following table gives the payoffs to the bond holders and the equity holders for the two projects under the two different states: Payoffs to Bond Holders Payoffs to Equity Holders Project Bad Good Bad Good Low Risk 500 500 200 High Risk 350 500 300 Obviously, the bond holders prefer the low risk project because they get more payoffs in the bad state. In contrast, the equity holders prefer the high risk project because they get more payoffs in the good state. (b) For the low-risk project there is no risk of default, hence the promised yield and the expected yield coincide: r P l = r E l = 500- 400 400 = 25% . For the high-risk project, the promised yield is the same as the one computed above. The expected yield is: r E h = (500 × . 5 + 350 × . 5)- 400 400 = 6 . 25% . (c) Suppose D h is the required debt payment for the high risk project. Since the equity holders will get zero in bad states for both projects, we only need to make sure the equity holders would get the same payoff in the good state. For the equity holders, the payoff of the high risk project in the good state is \$800- D h whereas the payoff of the low risk project in the good state is \$200. In order for the equity holders toof the low risk project in the good state is \$200....
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## This note was uploaded on 04/23/2011 for the course RSM 333 taught by Professor Sabrinabutti during the Spring '11 term at University of Toronto.

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RSM333mid09 SOLUTION - UNIVERSITY OF TORONTO Joseph L...

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