Problem 1 (16 points) _____

 

 

 

Consider the following information:

 

 

 

 

 

Stock A

 

Stock B

 

T-bills

 

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 risk-free 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 company’s stock should provide a greater return to investors?  Why? (4 points)

 

 

 

 

Problem 2 (12 points) _____

 

 

 

Consider the financial statements below for Media Motors.  The firm’s cost of capital is 10%.  The firm is stable, and the long-term growth rate for all items is expected to be 4%.  Their CEO’s name is Ray Charles.  Use the information below to estimate the fair market value of MM’s equity as of year-end 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

 

 

 

Long-term 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

 

 

 

Long-term 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., zero-coupon) 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 yield-to-maturity of 15%.  The common stock is currently priced at $70 per share, and has an estimated beta of 1.5.  The current risk-free rate is 6%, and the expected return on the market portfolio is 16%.  The company pays taxes at the rate of 40%.

 

 

 

Compute the firm’s 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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