Finance 1 – Problem Set 5 (week 6)

University of Amsterdam
Chapters 9.5, 12, 13

Introduction
Consult the relevant parts of the book and available Canvas videos and then answer the questions
below. For tutorial preparation, your answers need to be reasonable but do not have to be
completely correct. Please start work on this problem set before the lecture and hand in your
solutions before the tutorial.

Answers to SOLVE YOURSELF exercises are done at home

Parts of exercises marked [SOLVE YOURSELF] need to be done at home. You can check your
answers in this document. These exercises are not discussed in class unless there are questions.

Answers to normal (unmarked) exercises are prepared before class

Exercises that are not marked ‘solve yourself’ or ‘in class’ need to be completed before the tutorial
and students need to bring reasonable answers to class so they can be discussed.

Answers to IN CLASS exercises are completed in class

Parts of exercises marked [IN CLASS] will be completed during the tutorial. You can read the
questions and think about an answer but there is time during the tutorial to complete your answer.

Preparatory questions (optional)

0) Find a news item that discusses the relationship between risk and return of investments.
Think about how this relates to the CAPM.

Chapter 12: CAPM estimation

1) Consider the Capital Asset Pricing Model (CAPM). Explain a common way to estimate the:
a. risk-free rate.
The current return on safe government bonds
b. return on the market portfolio.
The historical return on the market index
c. beta. [IN CLASS]

2) Mattel Inc. is a producer of toys that is traded on the S&P500. You draw a scatterplot
between the monthly share returns (in %) of Mattel Inc. and the S&P 500 and find the
following result:

a. What is Mattel’s equity beta? What does this beta indicate?

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 0.9123
b. What is Mattel’s historical alpha? What does this alpha indicate?
0.0456%
c. Assume the current risk-free rate is 2% and the market risk premium is 5%.
Show that the expected return on Mattel’s shares is 6.56%. ´
0.02 + (0.9123*0.05) * 100 = 6,56%

3) In this question, you are going to empirically apply the CAPM model for Philips. The
questions below are designed to walk you through the process step by step.
Even if you can’t solve question a. you can continue with question b. and further as the beta
that you should find is already given.
The Excel file “Philips data” contains data from Datastream on the total return index (this
includes dividends) for Philips and the AEX index. Use this data to answer the questions
below. Note that the data on shares is formulated as a “Total return index”. This index is
equal to 100 when a share is first traded on the exchange, and increases with both
increases in the share price as well as dividends.

First transform the daily return index into daily returns using the formula:
rx,t = (xt - xt-1) / xt-1 where xt is the return index at day t.
Let’s try to use the CAPM to value Philips. First, you are going to estimate beta.
a. Create a scatterplot with the AEX’s daily returns on the horizontal axis and Philips’s
daily returns on the vertical axis and add a trendline.
b. Use the scatterplot or the standard formula for beta (with variance and covariance) to
show that the equity beta of Philips is about 1.23.
We now know the equity beta of Philips is 1.23. In what follows use as a measure of the risk-free
rate the yield on a 10-year Dutch Treasury Bond which is 0.6%. Take 6.16% as the historical
market risk premium.
c. Estimate Philips return on equity according to the CAPM model.
0.006 + 1.23 * 0.0616 * 100% = 8.2%

d. Verify online that Philips paid a dividend per share of €0.80 in 2016. Also verify that the
share price was around €31.60 in April 2017.
Philips dividend per share in 2016 was 0.80
(https://www.investing.com/equities/philips-kon-dividends)
The price of Philips Stock was around 31.64 in April 2017

e. Show that a constant growth rate of 5.7% is consistent with this share price and
dividend when investors use the constant growth perpetuity model.
f. Using P = DIV / (r-g), DIV / P = r – g, and so g = r – Div / P
= 0.082 – 0.8 / 31.6 * 100 = 5.7%.

g. What share price is consistent when investors use the constant growth perpetuity model
with the growth rate equal to 2.1% as projected by the CPB (Dutch bureau for Economic
Policy Analysis) for the Netherlands? [IN CLASS]
h. Do you find the share price under d. or the price under f. more realistic? [IN CLASS]

Chapter 9.5: Efficient Market Hypothesis (EMH)

4) Securities like stocks and bonds are traded on financial markets where it is important that
the prices of these securities are fair.
a. What does the Efficient Market Hypothesis (EMH) say about how stock and bond prices
are determined? [SOLVE YOURSELF]

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 b. What is the fair stock price of a firm that has no debt and 200.000 shares outstanding
and has as its only asset a factory that generates an end of year free cash flow (FCF) of
$100.000 in perpetuity. The discount rate for these free cash flows is 5% per year.
V = FCF / r = 100.000 / 0.05 = 2.000.000
c. What happens to the stock price if a manager within the firm has private information
that the FCF mentioned under b. will drop to $80.000 per year starting this year?
Assume the risk is unchanged.
What if this information becomes public knowledge because, say, it is published in a
newspaper? [IN CLASS]

Chapter 13: Behavioral Finance

5) Identify for each of the following situations based on the information provided if rational
behavior is applicable or if a behavioral finance concept (like overconfidence bias) applies.
a. Jill invests in a portfolio of stocks from industries she recalls from the news. [SOLVE
YOURSELF]
b. Jack selects his investments in stocks based on what his buddies are investing in.´
Herding

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 c. Sarah is pretty sure she can spot the difference between stocks that will be winners and
those that will be losers.
Overconfidence bias
d. Patrick will hold on to his investment in bonds until he can sell them at a price above the
price he paid originally.
Disposition effect
e. Peter has chosen to put all of his funds into the risk-free asset. [IN CLASS]
f. Wayne has chosen to put all of his money into stocks with a beta above 1. [IN CLASS]
g. Kyle decided to invest in bitcoin because of the high volatility. [IN CLASS]
h. Are any behavioral biases missing? [IN CLASS]

SOLVE YOURSELF ANSWERS

4a.
Price = PV cash flows (dividends) of the stock. So takes into account:
- Estimated cash flows in all future years
- Risk and the time value of money through the discount rate
- Based on all publically available information

5a. Familiarity bias