Problem 1 (16 points) _____
Consider the following information:

Stock A

Stock B

Tbills

Beta

0.6

1.2

0.0

Expected return, %

5.0

8.0

2.0

(a) Assuming that all stocks are priced correctly according to the CAPM, compute the expected return on the market portfolio. (4 points)
(b) Stocks are generally regarded as being risky investments. According to the CAPM, is it possible for a stock to have an expected return that is less than the riskfree rate? Explain. (4 points)
(c) Is it possible for a stock to have a negative standard deviation in returns? Explain. (4 points)
(d) Consider two separate stocks: the returns on the stock of AppleCo have a standard deviation of 32% and a beta of 0.9; the returns on the stock of BananaCo have a standard deviation of 20% and a beta of 1.2. Which companys stock should provide a greater return to investors? Why? (4 points)
Problem 2 (12 points) _____
Consider the financial statements below for Media Motors. The firms cost of capital is 10%. The firm is stable, and the longterm growth rate for all items is expected to be 4%. Their CEOs name is Ray Charles. Use the information below to estimate the fair market value of MMs equity as of yearend 2013.
2013 Income Statement


Sales

500

Cost of goods sold

250

SG&A expense

50

EBIT

200

Interest expense

40

Taxable income

160

Taxes

64

Net Income

96

2012 Balance Sheet


Cash

50


Accounts payable

70


Accounts receivable

100


Total current liab.

70


Inventory

200





Total current assets

350


Longterm debt

400








Gross fixed assets

1,000


Common stock

200


Accumulated depreciation

200


Retained earnings

480


Net fixed assets

800


Total equity

680


Total

1,150


Total

1,150


2013 Balance Sheet


Cash

70


Accounts payable

100


Accounts receivable

130


Total current liab.

100


Inventory

220





Total current assets

420


Longterm debt

450








Gross fixed assets

1,120


Common stock

250


Accumulated depreciation

270


Retained earnings

470


Net fixed assets

850


Total equity

720


Total

1,270


Total

1,270


Problem 3 (12 points) _____
(a) Arbitrage Financial is offering an investment with the following cash flows:
Year

1

2

3

4

Cash flow

$200

$400

$100

$500

(note that the cash flows in Years 1, 2, and 4 are positive, and the cash flow in Year 3 is negative.)
You observe the following prices of pure discount (i.e., zerocoupon) bonds, which pay a single cash flow of $100 at maturity:
Price, $

Maturity, years

95.24

1

89.85

2

83.96

3

77.73

4

What is a fair price (to the nearest dollar) for the investment from Arbitrage Financial? (6 points)
price of investment:

(b) Arbitrage Financial offers another product called a mystery coupon bond. This bond has a face value of $1,000 and a maturity of five years. The bond pays an annual coupon, but the amount of the coupon is unknown. However, you know that the price of the bond is $1,052.30, and bonds of similar risk and maturity currently have a yield to maturity of 6.25%. What is the annual coupon payment (to the nearest dollar) on this bond? (6 points)
Problem 4 (10 points) __________
The American Movie Company has the following sources of financing reported on its balance sheet:
Liabilities & Equity

Book Value

Debt (13% coupon bonds, $1000 face value)

$4,000,000

Common stock, 100,000 shares

$6,000,000

Total

$10,000,000

The bonds are currently selling for $900, and have a yieldtomaturity of 15%. The common stock is currently priced at $70 per share, and has an estimated beta of 1.5. The current riskfree rate is 6%, and the expected return on the market portfolio is 16%. The company pays taxes at the rate of 40%.
Compute the firms weighted average cost of capital. Where calculations are required, please show them in the table below.
Cost of

Estimated weight of

Debt:

Debt:

Common stock:

Common stock:

WACC =
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