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Exam questions

Corporate Finance And Financial Institutions (Università Ca' Foscari Venezia)

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FINANCIAL INSTITUTIONS AND CORPORATE FINANCE

ILLUSTRATIVE LIST OF THEORETICAL QUESTIONS (COVERING ALL THE

TOPICS OF THE FIRST PART)
Further questions will be added later during the course

Question
What does the separation theorem imply?
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Question
What are the primary determinants of a company beta (b)?

Question
What sort of investor rationally views the variance (or standard deviation) of an individual security’s return as the
security’s proper measure of risk

Question
What sort of investor rationally views the beta of a security as the security’s proper measure of risk?

Question
What’s the more common slope of the term structure of interest rates? In what circumstances has it a dowonward slope?
When do these circumstances occur?

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FINANCIAL INSTITUTIONS AND CORPORATE FINANCE

LIST OF EXERCISE QUESTIONS WITH GUIDELINES FOR SOLUTION

QUESTION 1

Assets Liabilities Equity Current Next Year Market Earning

income Income Price growth
Alfa 1,000k 600k 400k 40k 42k 5 8%
Beta 3,000k 2,000k 1,000k 140k 170k 10 6%

Number of stocks outstanding: Alfa = 150,000; Beta = 250,000.

What company is more expensive/cheap and has created more value for shareholders?

SOLUTION
First, you must compute the forward P/E: Price / Next Year Earning per Share
Alfa = 5 / (42k / 150k) = 17.86
Beta = 10 / (170k / 250k) = 14.71

Then you must compute the PEG ratio: P/E /(Earnign growth x 100)
Alfa = 17.86 / 8 = 2.32
Beta = 14.71 / 6 = 2.45

The Alfa’s PEG is lower than Beta’s: therefore Alfa is, for this aspect, cheaper.

To measure the value creation we use the Price to book value.

Book Value = Equity / Number of stock outstanding.

Alfa book value = 400k / 150k = 2.67

Beta book value = 1000k / 250k = 4.

Alfa price to book value = 5 / 2.67 = 1.875

Beta price to book value = 10 / 4 = 2.5

Beta has created more value for shareholders.

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QUESTION 2
In the last 4 years the cumulated return (= holding period return) has been 8.17%. The annual
returns in each year were: t-1 = 2%; t-2 = -1%; t-4 = 3%. What was the return in year t-3? What has
been the actual annual average return?

Solution
Holding period return = (1+0.02) x (1-0.01) x (1+t-3) x (1+0.03) – 1 = 0.0817
Return t-3 = (1+0.0817) / ((1+0.02) x (1-0.01) x (1+0.03)) – 1 = 0.04

The question asks to find the “actual average” return, which must be calculated with the geometric
mean of the holding period return.
(1+0.0817)1/4 – 1 = 0.0198

QUESTION 3
The annual returns in the last five years are: +5%; - 1.5%; + 1%; + 0.5%; -1.2%. Calculate the
holding period return and the annual geometric average return.

Solution
Holding period return = (1+0.05) x (1-0.015) x (1+0.01) x (1+0.005) x (1-0.012) – 1 = 3.72%

Geometric av. return = [(1+0.05) x (1-0.015) x (1+0.01) x (1+0.005) x (1-0.012)]1/5 – 1 = 0.733%

QUESTION 4
You have 20 years of annual returns data, with the average arithmetic return being 7% and the
geometric one 5%. Calculate the 3 years average annual return forecast.

Solution
We use the Blume’s formula.
T −1 N −T
R(T) = xGeometric Average + xArithmetic Average
N −1 N −1

Forecast = (3 – 1)/(20 – 1) x 0.05 + (20-3)/(20-1) x 0.07 = 6.79%

QUESTION 5
Consider the stock 1 and 2, whose standard deviations are respectively 8% and 10%, while their
correlation is -1. Calculate the weights W1 and W2 for which the portfolio risk is 0.

Solution

W1 = 0.1/(0.08 +0.1) = 0.555

W2 = 1 - 0.555 = 0.444

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QUESTION 6
Consider the stock 1 and 2, whose standard deviations are respectively 8% and 10%, while their
correlation is 0. Is it possible to build a portfolio whose risk is 0?

Solution
It is not possible because the risk can be 0 only when the stocks have a perfect negative correlation
(= -1).

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QUESTION 7
Consider stock 1 and 2, whose standard deviations are respectively 8% and 10%, while their
correlation is -1. The expected return for stock 1 is 5% and for stock 2 is 7%. Is a portfolio invested
60% in stock 1 efficient?

Solution
We calculate the zero risk portfolio.
W1 = 0.1/(0.08 + 0.1) = 0.555
W2 = 1 - 0.555 = 0.444

A portfolio whose Stock 1 weight is more than 0.555 is not efficient. Therefore, the portfolio in not
efficient.

QUESTION 8
The risk free return is 2%, while the expected return and standard deviation of the risky portfolio A
are respectively 6% and 9%. Calculate the portfolio weights to have a risk of 7%. What is the
portfolio expected return?

Solution
The risk of the portfolio made with risk and risk free is:
Riskp = WA x 0.09 = 0.07.
WA = 0.07/0.09 = 77.78%
Wrisk free = 1 – 0.7778 = 22.28%

Expected return portfolio = 0.7778 x 0.06 + 0.2228 x 0.02 = 5.11%

QUESTION 9
You are considering to invest in 20 securities with the same standard deviation (0.11) and
covariance (0.009). Calculate the portfolio standard deviation if you evenly invest among the 20
securities.

Solution

Portfolio variance = 1/20 x 0.112 + (1 – 1/20) x 0.009 = 0.00915

Portfolio standard deviation = 0.009151/2 = 9.57%

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QUESTION 10
The risk free return is 2%, while the expected return and standard deviation of the market portfolio
are 6% and 9%. The borrowing rate is 3%. Calculate the weight of the investment in the market
portfolio if your target expected return is 7%.

Solution
To reach the target expected return the investor must leverage the investment in the risky portfolio.
He must borrow cash, at the borrowing rate (3%, not 2%!).

Target expected return = (1 – Wrisky) x 0.03 + Wrisky x 0.06 = 0.07

0.03 - Wrisky x 0.03 + Wrisky x 0.06 = 0.07

Wrisky x (0.06 – 0.03) = 0.07 – 0.03

Wrisky = (0.07 – 0.03) / (0.06 – 0.03)

Wrisky = 1.3
Wrisk free = - 0.3

QUESTION 11
The market standard deviation is 8%, the stock A standard deviation is 12%, the correlation
between the stock and the market is 0.4. Calculate the stock A beta.

Solution

We derive the Covariance with the market.

Covariance = 0.4 x 0.08 x 0.12 = 0.00384

Beta = 0.00384/ 0.082 = 0.6

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QUESTION 12

Stock A. Expected Return = 1.2%; Standard Deviation = 1.4%

Stock B. Expected Return = 1.5%; Standard Deviation = 1.9%
Covariance of returns = 0.0002.
Calculate the return and the risk of a portfolio that is 20% invested in A and 80% in B. Calculate
also these data assuming the two stocks are perfectly correlated.

Solution
Expected return = 20% x 1.2% + 80% x 1.5% = 1.44%
Variance = 0.22 x 0.0142 + 0.82 x 0.0192 + 2 x 0.8 x 0.2 x 0.0002 = 0.0003029
Portfolio risk = 0.00030291/2 = 1.74%
When correlation is 1
Covariance = 0.014 x 0.019 = 0.000266
Variance = 0.22 x 0.0142 + 0.8022 x 0.0192 + 2 x 0.8 x 0.2 x 0.000266 = 0.000324
Portfolio risk = 0.0003241/2 = 1.80%

QUESTION 13
Portfolio A. Annual Expected return = 8%; standard deviation = 12%
Portfolio B. Annual Expected return = 11%; standard deviation = 16%
The annual risk free rate is 2%.
What portfolio would you choose?

Solution
We must calculate the Sharpe Index.
A = (8% - 2%) / 12% = 0.50
B = (11% - 2%) / 16% = 0.56
We must choose B.

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QUESTION 14
Stock A. Annual Expected return = 9%; standard deviation = 12%; Beta = 0.9
Stock B. Annual Expected return = 11%; standard deviation = 16%; Beta = 1.1
The expected market return is 10%. The annual risk free rate is 2%.
What stock would you pick?

Solution
We must first calculate the expected equilibrium returns for both stocks through the SML.
For A it is: 2% + (10% - 2%) x 0.9 = 9.2%
For B it is: 2% + (10% - 2%) x 1.1 = 10.8%
The Return on A is less than the SML return, the return on B is more than the SML return. We
should pick B.
The information about Standard deviation is irrelevant.

QUESTION 15
You have invested one year ago 50000 € in three stocks allocated in this way: 10000 € in A, 25000
€ in B and 15000 € in C.
The Price of the stocks when you bought them was: A = 10; B = 20; C = 15. The current price of
the stocks is: A = 13; B = 19; C = 16. The Beta of the stocks is: Beta A = 0.6; Beta B = 0.9; Beta C
= 1.1. Calculate the current beta of the portfolio.

Solution
We first calculate the number of stocks purchased: A = 10000/10 = 1000; B = 25000/20 = 1250; C
= 15000/15 = 1000.
We derive the current value invested in each stock:
A = 1000 x 13 = 13000; B = 1250 x 19 = 23750; C = 1000 x 16 = 16000.
The current portfolio value is = 52750.
The current percent weights of each stock are:
A = 24.64% (13000/52750); B = 45.02% ( 23750/52750) C = 30.33% (16000/52750).
The current beta of the portfolio is = 0.6 x 0.2464 + 0.9 x 0.4502 + 1.1 x 0.3033 = 0.89

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QUESTION 16
You have been provided the following data about three firms, the market portfolio and the risk-free
asset.
Expected Return Stand. Dev. Correlation* Beta
Firm A 13% 38% …..(i) 0.9
Firm B 16% ….. (ii) 0.40 1.1
Firm C 25% 65% 0.35 …..(iii)
Market Portfolio 15% 20% ….. (iv) …..(v)
Risk Free asset 5% ….(vi) ….(vii) ….. (viii)

*With the market portfolio

1) Fill in the missing values in the table
2) Are the expected returns of the 3 companies correctly priced according to the CAPM? If they are
not correctly priced, what would you recommend for a well diversified investor?

Solution
We start filling in the values that don’t require a specific computation
(iv) = 1; (v) = 1; (vi) = 0; (vii) = 0; (viii) = 0
Explain why these values.
(i) = (0.9 x 0.22) / (0.38 x 0.2) = 0.47
(ii) = (1.1 x 0.22) / (0.2 x 0.4) ) = 0.55 (55%)
(iii) = (0.35 x 0.2 x 0.65) / 0.22 = 1.1375

The expected return according to CAPM should be:

A = 5% + (15% - 5%) x 0.9 = 14%
B = 5% + (15% - 5%) x 1.1 = 16%
C = 5% + (15% - 5%) x 1.375 = 16.38%

Company A has an expected return less than the equilibrium one and therefore it shouldn’t be
picked up (Recommendation = sell).
Company B has an expected return equal to the equilibrium one and therefore it can be held
(Recommendation = hold).
Company C has an expected return more than the equilibrium one and therefore it should be picked
up (Recommendation = buy).

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QUESTION 17
The current annual interest rates for the following maturities are: 12 months = 1.3%; 2 years =
1.6%; 3 years = 2%. According to the expectations theory, what’s the 1 year expected interest rate
within 2 years (E(3R1))?

Solution
We must first calculate the 1 year expected interest rate within 1 year E(2R1).

(1 + 0.013) x ( 1+ E(2R1)) = (1 + 0.016)2

E(2R1) = (1 + 0.016)2/ (1 + 0.013) – 1 = 1.90%

The 1 year expected interest rate within 2 years E(3R1) will be:

(1 + 0.013) x (1 + 0.019) x (1 + E(3R1)) = (1 + 0.02)3

E(3R1) = (1 + 0.02)3 /((1 + 0.013) x (1 + 0.019)) – 1 = 2.80%

QUESTION 18
The yield curve is: 1R1 = 1%; 1R2 = 1.3%; 1R3 = 1.7%. On the basis of the liquidity premium theory,
calculate the E(2R1) and E(3R1), knowing that L2 = 0.1% and L3 = 0.2%.

Solution

(1 + 0.013)2 = (1 + 0.01) x (1 + E(2R1) + L2 )

E(2R1) = (1+ 0.013)2 / (1+ 0.01) – 1 – 0.001 = 0.015

(1 + 0.017)3 = (1 + 0.01) x (1 + 0.015 + 0.001) x (1 + E(3R1) + L3)

E(3R1) = (1 + 0.017)3 / [(1 + 0.01) x (1 + 0.015 + 0.001)] – 1 – 0.002 = 2.3%

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QUESTION 19
Suppose the current one year rate and expected one year rates over the following three years (years
2, 3 and 4 respectively) are as follows:
1R1 = 2%; E(2r1) = 3%; E(3r1) = 3.5%; E(4r1) = 3.7%;

Using the unbiased expectations theory, calculate the long term current rates for 2, 3 and 4 years
maturity.

Solution
We must first calculate the 1R2.

(1 + 0.02) x ( 1+ 0.03) = (1 + 1R2)2

1R2 = 0.025 (2.5%)

Then, 1R3.
(1 + 0.02) x ( 1+ 0.03) x (1 + 0.035)= (1 + 1R3)3
1R3= 0.0283 (2.83%)

Then, 1R4.
(1 + 0.02) x ( 1+ 0.03) x (1 + 0.035) x (1 + 0.037) = (1 + 1R4)4
1R4= 0.0305 (3.05%)

QUESTION 20
Calculate the expected inflation rate when the nominal interest rate is 13% and the real interest rate
is 8%.

Solution
Inflation = (0.13 – 0.08) / (1 + 0.08) = 4.62%

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QUESTION 21
Rearrange the following items of the income statement of a bank following a multi steps approach
where the most important profitability results are shown.

Amortization and depreciation of assets 5

Income tax 12
Intererest paid 60
Interest earned 100
Net fees and commissions 35
Net trading, hedging and fair value income 20
Other administrative expenses 20
Payroll costs 30
Provisions for risks and charges 3
Write off and provisions on loans 10

Solution

Bank income statement

Interest earned 100
Intererest paid 60
Net Interest 40
Net fees and commissions 35
Net trading, hedging and fair value income 20
OPERATING INCOME 95
Payroll costs 30
Other administrative expenses 20
Amortization and depreciation of assets 5
OPERATING PROFIT 40
Write off and provisions on loans 10
NET OPERATING PROFIT 30
Provisions for risks and charges 3
PROFIT BEFORE TAX 27
Income tax 12
NET PROFIT 15

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QUESTION 22
This is a simplified version of a balance sheet of a bank.

Assuming that: tax rate = 30%; interest on cash = 0; interest on securities held = 2%; Other assets =
don’t provide income; interest on deposits =1%; interest on securities issued = 1.5%; write-off on
loans = 0.9% of book value; non interest income = 1€; operating costs = 1.5€.
The required ROE = 9.87%. What should be the average interest on loans?

Step 1: the net income can be derived from income before tax multiplying it with (1 – tax rate) =
0.7.
Step 2: ROE =9.87% implies that NI = 0.0987 x 10 = 0.987

Step 3. Write the equation of the net income, with unknown variable the interest rate on loans.

[(25 x 0.02 + 60 x int_rate + 1) – (60 x 0.01 + 30 x 0.015 + 1.5 + 60 x 0.009) ] x 0.7 = 0.987

60 x int_rate = 0.987/0.7 + (60 x 0.01 + 30 x 0.015 + 1.5 + 60 x 0.009) - 25 x 0.02 – 1

60 x int_rate = 3
int_rate = 3/60 = 0.05

The interest rate on loans must be 5%.

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MULTIPLE CHOICE QUESTIONS

Correct Answer = + 2; Wrong answer = - 0.5; No answer = 0. Answer writing “X” on the letter of the chosen
answer.

1) Bonds issued by commercial banks are subject to reserve requirements:

A) If they have been issued with a maturity less than 2 years

B) Never
C) If their current maturity is less than 2 years
D) If their current maturity is less than 2 years and are not listed in an organized market

2) According to the liquidity premium theory of interest rates:

A) long term spot rate are unrelated to the expectations of future short term rates
B) investors are indifferent between different maturities if the long term spot rates are equal to the average of current
and expected future short term rates
C) long term spot rates are higher than the average of current and expected future short term rates
D) the term structure must be upward sloping

3) The operating income of a bank is:

A) The difference between net interest and net commissions, considering also payroll costs
B) The difference between net interest and net commissions, considering also write off and provisions on loans
C) The difference between net interest and net commissions
D) The difference between net interest and net commissions, considering also amortization and depreciation of assets

4) The dividend yield of growth stocks is usually:

A) Relatively high
B) Relatively low, but always more than zero
C) Not different from other stocks
D) Relatively low, not rarely zero

5) The market standard deviation is 10%, the stock A standard deviation is 15%, the correlation between the
stock and the market is 0.7. Calculate the stock A beta

A) 1.05
B) 0.47
C) 0.83
D) 1.22

6) Holding fixed the market portfolio, the CAMP implies that an increase of the return of the riskless asset has
the following effect on the expected return of a stock:

A) An increase
B) A decrease
C) An increase if the beta is more than 1
D) A decrease if the beta is more than 1

7) Consider stock 1 and 2, whose standard deviations are respectively 8% and 10%, while their correlation is 0.4.
The standard deviation of a portfolio invested 30% in stock 1 and 70% in stock 2 is:

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A) 7.84%
B) 0.68%
C) 8.26%
D) 9.53%

8) The current annual interest rates for the following maturities are: 12 months = 0.4%; 2 years = 1%. According
to the expectations theory, what’s the 1 year expected interest rate within 1 year (E(2R1))?

A) 1.60%
B) 0.60%
C) 101.60%
D) 0.70%

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Correct answers
1 A 5 A
2 C 6 D
3 C 7 C
4 D 8 A

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