Question

1. You are a financial analyst at Bank of BU. Your supervisor asks you to study two stocks, Cosi and Pepca. After research, you have the following information: • In scenario 1, Cosi’s return is 8.5%, and Pepca’s return is 4%. Market return is 6%. • In scenario 2, Cosi’s return is 26.5%, and Pepca’s return is 28%. Market return is 18%. • The risk free rate is 5%. • There are only two possible scenarios. Your supervisor asks you to obtain the following information (show the steps of your calculation for full credits): a. What are the betas of Cosi and Pepca? (4 pt) b. What is the expected rate of return on each stock, if the two scenarios are equally likely to happen? (6 pt) c. Bank of BU is going to invest in a project that contains similar risk characteristics to Pepca. What required rate of return should be used to evaluate this project? Why? (3 pt) d. What are the alp

Answer 1

(a) Stock Return or CAPM or Expected Rate Of Return = R_f + (R_m - R_f)

SCENARIO 1

COSI	PEPCA
Given Data in the Question: Stock Return = 8.5% Market Return (Rm) = 6% Risk free rate (Rf) = 5%	Given Data in the Question: Stock Return = 4% Market Return (Rm) = 6% Risk free rate (Rf) = 5%
(a) Beta Calculation	a) Beta Calculation

SCENARIO 2

COSI	PEPCA
Given Data in the Question: Stock Return = 26.5% Market Return (Rm) = 18% Risk free rate (Rf) = 5%	Given Data in the Question: Stock Return = 28% Market Return (Rm) = 18% Risk free rate (Rf) = 5%
(a) Beta Calculation	(a) Beta Calculation

(b) If both the scenarios are equally likely to happen,

COSI	PEPCA
Expected Rate of Return = R1P1 + R2P2 P1 & P2 = Probability of return being achieved in scenarios = Both are 0.5 R1 & R2 = Return expectation in given scenarios = 8.5% & 26.5% Expected Rate of Return = (8.5) (0.5) + (26.5) (0.5) = 17.5%	Expected Rate of Return = R1P1 + R2P2 P1 & P2 = Probability of return being achieved in scenarios = Both are 0.5 R1 & R2 = Return expectation in given scenarios = 4% & 28% Expected Rate of Return = (4) (0.5) + (28) (0.5) = 16%