actsc372_f08_a4soln

# actsc372_f08_a4soln - Actsc 372 F08 Assignment 4...

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Actsc 372 F08: Assignment 4 Solution (Total marks: 35) Q1: [6 marks, 2 marks each] a. If m is the systematic risk portion of return, then: m = β GNP Δ GNP + β r Δ Interest rates m = 2.04(4.8% – 3.5%) – 1.90(7.80% – 7.10%) = 1.32% b. The unsystematic is the return that occurs because of a firm specific factor such as the increase in market share. If ε is the unsystematic risk portion of the return, then: ε = 0.36(27% – 23%) = 1.44% c. The total return is the expected return, plus the two components of unexpected return: the systematic risk portion of return and the unsystematic portion. So, the total return of the stock is: ε + + = m R R R = 10.50% + 1.32% + 1.44% = 13.26% Q2) [4 marks] The discount rate for the project is equal to the expected return for the security, R S , since the project has the same risk as the firm as a whole. Apply the CAPM to express the firm’s required return, R S , in terms of the firm’s beta, β , the risk–free rate, R F , and the expected market return, R M . R S = R F + β × ( R M R F ) = 0.05 + 1.6 (0.09) = 0.194 Subtract the initial investment at year 0. To calculate the PV of the cash inflows, apply the annuity formula, discounted at 0.194. NPV = C 0 + C 1 A T r = –\$1,450,000 + \$510,000 A 5 0.194 = \$ 277.402.65 Undertake the project since the NPV is positive. Q3) [4 marks] a. Lang Cosmetics should use its stock beta in the evaluation of the project only if

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