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Question 1. 10 points) Both Berkley and Oakley are large public corporations with subsidiaries throughout the world. B
centralized approach and makes most of the decisions for its subsidiaries. Oakley uses a decentralized approach and its
many of their own decisions.
a. Would the agency problem be more pronounced for Berkley or for Oakley? Explain.

Agency problems would be more pronounced(prominent) for Oakley as compared to Berkley.

Because Decentralization facilitates more efficient use of local information but also can lead to agency problems and commitmen

b. Would agency costs likely be higher for Berkley or Oakley? Why?

Agency costs would be higher for Oakley as compared to Berkley Because decentralized management increases

may result in better decisions

c. Discuss a major advantage and a major disadvantage to a centralized approach such as Berkley uses.

Advantage:Centralized reduces agency costs because it gives parent more control

Disadvantage:Downside is that it does not result in better decision making as local managers ma

informed about their particular subsidaries

d. Discuss a major advantage and a major disadvantage to a centralized approach such as Oakley uses.

Advantage:It results in better decision making as local managers may be better informed abou

subsidaries.
Disadvantage:-It also can lead to agency problems and commitment failures.

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subsidaries.
Disadvantage:-It also can lead to agency problems and commitment failures.

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e. Which is better, a centralized or decentralized approach? Explain.

Every organization must establish whether its decision-making policies are centralized or
decentralized.Highly centralized companies tend to have more bureaucratic traits, while hig
companies tend to appear more out of control.Both extremes appear engulfed with inefficien
waste.High performance work systems seem to have more decentralized decision-making fe
culture, formed around their philosophy and values, is highly centralized.Creating a centraliz
and value system allows employees to become more empowered to make their own decision
decentralization will be the best approach which can be considered leading to win-win situatio

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subsidiaries throughout
the world. Berkley uses a
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uses a decentralized
approach
and its subsidiaries make
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lain.
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kley.
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ead to agency problems
and commitment failures.
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lized management
increases agency costs but
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uch as Berkley uses.
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nt more control
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making as local
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uch as Oakley43
uses.
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may be better
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ment failures.
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ment failures.

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policies are centralized or

bureaucratic traits, while highly decentralized
ppear engulfed with inefficiencies and
entralized decision-making features, yet their
ntralized.Creating a centralized philosophy
d to make their own decisions, leading to
ed leading to win-win situation

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Question 2. (20 points) Assume the firm's stock now sells for $30 per share. The company wants to raise $20 million by issu
interest, $1,000 par value bonds. Each bond will have 40 warrants attached, each exercisable into 1 share of stock at an exer
firms straight bonds yield 8%. Each warrant is expected to have a market value of $0.75 when the stock sells at $30. The
establish a coupon interest rate and dollar coupon to ensure that the bonds will clear the market.

Stock price
Bonds-life and par value
Par value
# of warrants per bond
Exercise price
Warrant market value @ P=$30)
Yield on straight bonds

$30
20
$1,000
40
$36
$0.75
8%

b. Calculate the dollar coupon amount per bond with warrants.

Number of warrants per bond
Warrant market value @ P=$30)
Dollar coupon amount per bond with warrants

40
$0.75
$30

a. Calculate the value of the debt portion of the bonds with warrants.
V (package)
V(warrants)
V(Bonds with warrants)

$1,000
$30
$970

c. Calculate the coupon interest rate that should be set on the bonds with warrants.

Present Value
$970
c. What is the effect on
earnings
if it is assumed that profits before interest and taxes will b
Future
Valueper share of each alternative, $1,000
percent of total assets.
Number of years
20
Payment
$80
Coupon interest Rate
8.313%

d. Identify 2 or 3 advantages to the company of issuing a bond with warrants instead of straight bonds.
Ans d) Advantages to the company of issuing a bond with warrants instead of straight bonds:I)Warrants are priced based upon the implied volatility assigned to the underlying stock; the greater the volatility, the greater the val
market overestimates the firms volatility, the firm may
gain14e
by using warrants and option-like securities.
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2)Warrants are priced based upon the implied volatility assigned to the underlying stock; the greater the volatility, the greater the val

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d. Identify 2 or 3 advantages to the company of issuing a bond with warrants instead of straight bonds.
Ans d) Advantages to the
instead
bonds:A company of issuing a bond with warrants
B
C of straight D
I)Warrants are priced based upon the implied volatility assigned to the underlying stock; the greater the volatility, the greater the val
market overestimates the firms volatility, the firm may
gain by using warrants and option-like securities.

2)Warrants are priced based upon the implied volatility assigned to the underlying stock; the greater the volatility, the greater the val
market overestimates the firms volatility, the firm may
gain by using warrants and option-like securities.

3)For financial officers who are sensitive to the dilution created by issuing common stock, warrants seem to provide the best of both
create any new additional shares currently, while they raise equity investment funds for current use.

Ques e. Identify 2 or 3 advantages to the investor of buying a bond with warrants in

bonds
1)At maturity the convertible bondholder can choose to receive the payment on the bond or co
The value of the convertible bond is therefore the higher of its bond value and its conversion va

2)Exercise means that each shareholder is entitled to a smaller proportion of the firm's assets a
ofdilutionnever arises with traded options. If investor buys an option through an option excha
exercise it, investors have no effect on the number of shares outstanding.

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y wants to raise8$20 million by issuing 20-year, annual
ble into 1 share of stock at an exercise price of $36. The
when the stock9sells at $30. The company wants to
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market.
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b. Calculate the dollar coupon amount per bond with warrants.
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Number of warr
40
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Warrant marke
$0.75
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Dollar coupon
$30
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its before interest
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raight bonds. 49
straight bonds:50
ater the volatility, the greater the value. To the degree that the

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ater the volatility, the greater the value. To the degree that the

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raight bonds.
straight bonds:E
F
G
ater the volatility,
the
greater
the
value.
To
the
degree
that
the
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ater the volatility,
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ants seem to provide
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use.
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a bond with
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payment on the bond or convert to common stock.

value and its conversion value.

ortion of the firm's assets and profits.This problem

on through an option exchange and subsequently
nding.

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Question 3. (15 points) Mantra Corporation is interested in acquiring Corlos Corporation. Corlos has 10 million shares ou
consisting of 30 percent debt and 70 percent equity. The debt interest rate is 8%. Assume that the risk-free rate of interest

Corlos' free cash flow (FCF0) is $5 million per year and is expected to grow at a constant rate of 6 percent a year; its beta is
rate for both companies is 30%.

Shares outstanding
Target debt in capital structure
Debt interest rate
rRF

10,000,000
30%
8%
3%
7%
30%

Market risk premium

Tax rate

a. Calculate the required rate of return on equity using equation: rs= rRF + RPM(b)
rRF
Market risk premium
Beta
Required Rate of Return on equity

3%
7%
1.2
11.40%

b. Calculate weighted average cost of capital, using equation: WACC = Wdrd(1-%) + w

Target debt in capital structure
So Target Stocks in capital structure
Tax rate
WACC

30%
70%
30%
9.66%

c. Calculate the value of operations, using equation: Vops = FCF0(1+g)/WACC - g)

FCF0
Constant growth rate(g)
WACC
Vops

5,000,000
6%
9.66%
144,808,743.17

d. Calculate the value of the company's equity, using equation: Vs = Vops - debt

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Vops
Amount of debt
Value of Company's Equity

$
$
$

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144,808,743.17
5,000,000.00
139,808,743.17

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e. Calculate the current value of the company's stock.

Value of Company's Equity
Shares outstanding
current value of the company's stock.

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$
$

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139,808,743.17
10,000,000
13.98

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0
0

5
ring Corlos Corporation.
Corlos has 10 million shares outstanding and a target capital structure
rest rate is 8%.6 Assume that the risk-free rate of interest is 3% and the market risk premium is 7%.
7
d to grow at a constant
rate of 6 percent a year; its beta is 1.2. Corlos has $5 million in debt. The tax
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FCF0
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5,000,000
Constant growth rate
6%
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Beta
1.2
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Amount of debt
5,000,000
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C = Wdrd(1-%)26
+ wsrs
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28 Debt interest rate
29 Required Rate of Return on eq
30 1-Tax Rate
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8%
11.40%
70.00%

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Question 4. (20 points) A Treasury bond futures contract settled at 97'16.
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a. Calculate the present value of one futures contract?
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A quote for a Treasury bond futures contract of 97-16 means 97 and 16/32nds, or 97.50.So if
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seller agree on a futures price of 97-16, this means that the buyer agrees to accept delivery
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hypothetical underlying Treasury bond and pay 97.50% of par value, and the seller agrees to
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of par value.
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If the par value is $100,000, the futures price that the buyer and seller agree to transact for
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hypothetical Treasury bond is $97,500
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b. Are current market interest rates higher or lower than the standardized rate on a futures contract? Explain.
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For this question to be answered we should be cognizant of futures contract settlement price which is not mentioned
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question
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29 c. Calculate the implied annual interest rate on the futures contract.
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Implied Annual Rate=Future Rate-Spot Rate.
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For this question to be answered we should be cognizant spot rate which is not mentioned
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given question
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d. Calculate the new value of the futures contract if interest rates increase by 1 percentage point annually.
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For this question also current interest rate must be given.So that new value of the future
47
contract can be evaluated if interest rates increase by 1 percentage point annually.
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For this question also current interest rate must be given.So that new value of the future
contract can be evaluated if interest rates increase by 1 percentage point annually.
A
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e. Why do companies enter into futures contracts? Provide a specific example.

Companies enter into futures contracts.because Futures contracts detail the quality and quantity of the underlying asset and they ar
to facilitate trading on a futures exchange
The futures markets are characterized by the ability to use very high leverage relative to stock markets
Future Contracts are also used to hedge risk.
For Eg:-Suppose a company enters into a short cotton futures contract when the future price is 50 cents
per pound. The contract is for the delivery of 50,000 pounds.
Company will gain if the cotton price at the end of the contract is >50 cents
Gain = ($0.5000 $0 .4820) X 50,000 = $900 (if end price is $48.20 cents per pound)

Company will lose if the cotton price at the end of the contract is <50 cents
Loss = ($0.5130 $0.5000) X 50,000 = $650.(if end price is $51.30 cents per pound)

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d 16/32nds,12
or 97.50.So if a buyer and
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agrees to accept
delivery of the
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, and the seller
agrees to accept 97.50%
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ller agree to
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ures contract? Explain.
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nt price which21
is not mentioned in the given
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e which is 34
not mentioned in the
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w value of the
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point annually.
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w value of the future

point annually.
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of the underlying asset and they are standardized
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arkets
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cents per pound)
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Question 5. (20 points) Corizon Company's balance sheet and income statement are shown below (in millions of dollars). C
voluntary reorganization plan. In this plan, each share of the $5 preferred will be exchanged for one share of $2.00 preferre
income debenture with a par value of $50. The $8 preferred issue will be retired with cash. The company's tax rate is 30%

Balance Sheet prior to Reorganization (in millions)

Current Assets
Net fixed assets

200
225

Total assets

425

a. Construct the pro forma balance sheet after reorganization takes place. Show the new preferred at its par value.
Balance Sheet after Reorganization (in millions)
Current Assets
Net fixed assets

200
225

Total assets

425

b. Construct the pro forma income statement after reorganization takes place. How does the recapitalization affect net inco

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C
Income Statement (in millions)

Prior to Reorganization
Net sales
Operating expense
Net operating income
Other income

EBT
Taxes
Net income
Dividends on $5 PS
Dividends on $8 PS
Income to Common SHs

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700.0
630.0
70.0
7.0

77.0
23.1
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0.6
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c.

Calculate the required pre-tax earnings before and after the recapitalization?

74 Pretax Earning Before

and after the recapitalization
77.0
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85 d. Calculate the debt ratio before and after the reorganization?
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43.53%
87 Debt Ratio
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95 e. Would the common stockholders be in favor of the reorganization? Why or why not?
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Yes they will be in favour of reorganization as value of income to share
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holders is increasing.
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8 are shown below (in millions of dollars). Corizon and its creditors have agreed upon a
d income statement
9 be exchanged for one share of $2.00 preferred with a par value of $50 plus one 10% subordinated
$5 preferred will
10 with cash. The company's tax rate is 30%.
ssue will be retired
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14
Balance Sheet
15prior to Reorganization (in millions)
175
16 Current liabilities
10
17 Advance payments
100
18 $5 preferred stock, $100 par value (1,000,000) shares
8
19 $8 preferred stock, no par, callable at 100 (80,000 shares)
25
20 Common stock, $1.00 par value (5,000,000) shares
107
21 Retained earnings
425
22 Total claims
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takes place. Show
29 the new preferred at its par value.
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Balance Sheet
31 after Reorganization (in millions)
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175
33 Current liabilities
Advance
payments
10
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50
35 $2 preferred stock, $50 par value (1,000,000) shares
50
36 one 10% subordinated income debenture with $50 par value
8
37 $8 preferred stock,retired as cash
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38 Common stock, $1.00 par value (5,000,000) shares
107
39 Retained earnings
425
40 Total claims
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ation takes place.
46 How does the recapitalization affect net income available to common stockholders?
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Income Statement
(in millions)
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After Reorganization
54 Net sales
55 Operating expense
56 Net operating income
57 Other income
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60 EBT
61 Taxes
62 Net income
63 Dividends on $2 PS
64 Dividends on $8 PS
65 10% subordinated income debenture with a par value of $50
66 Income to Common SHs
67 Net Income Increase

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700.0
630.0
70.0
7.0

77.0
23.1
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2.0
0.6
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he recapitalization?
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ation? Why or95why not?
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s value of income to share
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rs?

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Question 6. (15 points) Your portfolio is diversified. It has an expected return of 10.0% and a beta of 1.10. You want to
your portfolio. Tundra has an expected return of 14.0% and a beta of 1.30. The total value of your current portfolio is $50
a. Calculate the expected return on the portfolio after the purchase of the Tundra stock?

Initial Portfolio Value

Initial
Portfolio Beta
Initial
Portfolio Return

Final Portfolio Value

24 Weightage of Initial Portfolio
after the purchase of the Tundra stock
25

50,000.00
1.1
10%

65,000.00
0.7692307692

26 Expected Return on final portfolio

after the purchase of the Tundra stock
10.92%
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40
b. Calculate the expected beta on the portfolio after you add the new stock?
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45 Expected Beta on final portfolio
after the purchase of the Tundra stock
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1.15

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c. Is your portfolio less risky or more risky than average? Explain.

Ans c)As Beta is more than 1(1.15) ,this portfolio is more risky than average as systematic risk is more than market risk.

d. Will your portfolio likely outperform or underperform the market in a period when stocks are rapidly falling in value? E
Ans d)As stock markets are rapidly falling in value,portfolio will not be aple to perform as compared to market(it will underperform

e. Is beta always an accurate predictor of a portfolio's performance? Explain?

Ans e )Beta calculates the expected return of portfolio based on its beta and expect
Ans e)It can be considered as a near predictor (in cases where unsystematic risk is totally dive
as it measures systematic risk of portfolio in comparison to the market as a whole.
Unsystematic Risk can be reduced to extent by diversification of portfolio

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0
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6
7 of 10.0% and a beta of 1.10. You want to add 500 shares of Tundra Corporation at $30 a share to
expected return
8 total value of your current portfolio is $50,000.
beta of 1.30. The
9
chase of the Tundra
10 stock?
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500
17 Tundra No of shares
18 Tundra Price per share
$30
$
15,000.00
19 Tundra Portfolio Value
1.3
20 Tundra Portfolio Beta
21 Tundra Portfolio Return
14%
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Weightage of Tundra Portfolio

0.2307692308

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he new stock? 40
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lain.
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n average as systematic
risk is more than market risk.
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arket in a period
t be aple to perform
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ance? Explain?
64
of portfolio
65 based on its beta and expected market returns.
n cases where
66 unsystematic risk is totally diversified) of portfolio's performance

mparison to the market as a whole.

iversification of portfolio

Brigham 14e

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