Week 2 problems

# Week 2 problems - Week 2 Solution Guide B12(CAPM Owego...

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Week 2 Solution Guide; B12. (CAPM) Owego Storage and Housing, Inc., is considering building a new warehouse in Endicott, New York. Owego Storage has 2 million common shares outstanding. The share price is \$11. Assume rf = 4.5%, ß = 0.75, and rM - rf = 11.5%. Estimate Owego Storage’s required return on its equity investment in the new warehouse. r = r f + β(r M - r f ) r = 0.045 + 0.75(0.115) = 0.13125 = 13.125% C1. (Beta and required return) The riskless return is currently 6%, and Chicago Gear has estimated the contingent returns given here. 1. Calculate the expected returns on the stock market and on Chicago Gear stock. 2. What is Chicago Gear’s beta? 3. What is Chicago Gear’s required return according to the CAPM? Realized Return State of the Market Probability that State Occurs Stock Market Chicago Gear Stagnant 0.20 (10%) (15%) Slow growth 0.35 10 15 Average growth 0.30 15 25 Rapid growth 0.15 25 35 a. Expected Return M = 0.20 x -.10% + 0.35 x 10% + 0.30 x 15% + 0.15 x 25% = 9.75% Expected Return Chicago Gear = 0.20 x -.15% + 0.35 x 15% + 0.30 x 25% + 0.15 x 35% = 15.00% b. σ M 2 = 0.20(-0.10 - 0.0975) 2 + 0.35(0.10 - 0.0975) 2 + 0.30(0.15 - 0.0975) 2 + 0.15(0.25 - 0.0975) 2 = 0.0121 Cov(Chicago Gear, M) = 0.20(-0.15 - 0.15)(-0.10 - 0.0975) + 0.35(0.15 - 0.15)(0.10 - 0.0975) + 0.30(0.25 - 0.15)(0.15 - 0.0975) + 0.15(0.35 - 0.15)(0.25 - 0.0975) = 0.018

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Week 2 problems - Week 2 Solution Guide B12(CAPM Owego...

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