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 =