Solutions to FIN701 Spring 2020 Quiz 5 Exam Questions

This document provides detailed solutions to the questions from FIN701 Quiz 5, covering key concepts in finance. The solutions include explanations for questions on operating leverage, the Capital Asset Pricing Model (CAPM), expected return calculations, and the impact of fixed costs on a company's beta. The document also addresses questions related to risk premium, holding period return, and weighted average cost of capital (WACC). It includes calculations for debt-equity ratios and explores the relationship between risk and return, the mean value of probability distribution, and the standard deviation of stock returns. Furthermore, it provides step-by-step solutions for problems involving capital gains, dividend returns, and the valuation of stocks. Overall, the document offers a comprehensive guide to understanding and solving the quiz questions, aiding students in grasping fundamental finance principles.

Exam PDF 3

Exam pdf 3:
Part 1: a: As the fixed cost being higher increases the operating leverage of the company.
This implies if the sales would increase by 10% and the company has an operating leverage
of 3 the profit would increase by 30% which would happen even if the sale falls by 10% the
profit would reduce by 30%. Operating leverage is calculated as Sales-(price –variable cost)/
Sales-(price –variable cost)- fixed cost. Hence fixed cost directly impacts the operating
leverage of the company, hence increases the risk which increases the Beta more than the
industry.
Part 2:d: Expected Return = RF +( Market Return – RF) * Beta of stock
Part 3: b : The highest return is provided by the small cap stocks also since they are the most
risky while the lowest from the US t bills being the least risky
Part 4: d: The expected return is given by Expected return * probability of each state
Part 5: c:
13% is the mean value of the probability distribution, while we would be required to calculate
the Return^2*Probability for each period.
BOOM = 0.2^2 * 0.5 = 0.02
NORMAL = 0.1^2 * 0.4 = 0.004
Recession = -0.1^2 * 0.1 = 0.001
Sum of the values = 0.02 + 0.004 + 0.001 = 0.025
Probability = (0.025 – 0.13^2)^0.5 = (0.025 – 0.0169)^0.5 = (0.081)^0.5 = 9%
Part 6: d: Expected Return = 3.84% +(7.78 * 0.75) = 9.675% = 9.68%
Part 7: d: We initially calculate the weights of the debt and equity from the WACC formula

WACC= We*Ce + Wd*Cd*(1-Tax)
0.115 = w1*0.1395 +(1-w1)*(0.078*(1-0.34)
0.115 = 0.1395W1 +0.05148 – 0.05148W1
0.06352 = 0.08802 W1 = W1 = 0.06352/0.08802 = 72.16% W1 while W2 = 27.83%
W1 is the weight of equity while W2 is the weight of debt hence the debt equity ratio is given
by debt/ equity which is 72.16/27.83 = 38.58%
Part 8: a: The unsystematic risk is the risk which affects an individual company, while the
examples provided is of the systematic risk.
Part 9: d: The standard deviation is a measure of risk for a security and there is a direct
relationship between the stock expected return and risk.
Part 10: b: The total capital gain = selling price – purchase price = 7319 – (300*21.19) = 962.
The total dollar return = Capital gain + dividend = 962+300 = 1282
Part 11: b:
The holding period return is calculated by the following formula,
Selling price + dividend – purchase price / purchase price
=(10.2*53)+(0.53*4*53)-(53*13.48)/(53*13.48)
=540.6 +112.36 – 714.4/714.4 = -61.44/714.4 = -8.61%
Part 12: d: The additional return which is received by taking additional risk is known as risk
premium.
Part 13: c: The total return is = Capital Gain + dividend yield

Part 14: c: It is the average of the different source of capital which is present in the capital
structure of the company.
Part 15: b: As per CAPM Expected Return = RF +( Rm-RF)*Beta if beta is 0 then
Expected Return = RF + 0