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1. Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the
market risk premium is 6%? (10 points)
Stock
A
B
C
1.25
0.80 1.06
Beta
Expected Return 12.6% 8.8% 11.2%
E(RA)=4+1.25*6=11.5% under priced
E(RB)=4+0.80*6=8.8% correctly priced
E(RC)=4+1.06*6=10.36% under priced
2. The risk-free return is 6% and the expected market return is 14%. The market standard
deviation is 20% and the standard deviation for Acme Meat Company is 36%. The
correlation between the market and Acme returns is 0.80. (10 points)
a. What is the beta for shares of Acme?
=(0.8*0.36)/0.20 = 1.44
b. What is the required return on Acme’s stock?
R=6+1.44(14-6)=17.52%
3. Exxon Mobil’s required return for equity is 14%. Its required return for debt is
8%, its debt-to-total value ratio is 35% and its marginal tax rate is 40%. Calculate
Exxon Mobil’s WACC. (5 points)
WACC = .65(14)+.35(8)(.6)=10.78%
4. The S&P 500 index returns of common stocks for the period 1981-1985 are as
follows. Calculate the five-year holding-period return. (5 points)
1981 1982 1983 1984 1985
S&P 500 Return -4.96 22.45 23.76 7.27 32.16
(0.9504)(1.2245)(1.2376)(1.0727)(1.3216)=2.0418
2.0418-1=104.18%
5. Consider a project to supply Detroit with 35,000 tons of machine screws annually
for automobile production. You will need an initial $1,500,000 investment in
threading equipment to get the project started; the project will last for five years.
The accounting department estimates that annual fixed costs will be $300,000 and
that variable costs should be $200 per ton; accounting will depreciate the initial
fixed asset investment straight-line to zero over the five-year project life. It also
estimates a salvage value of $500,000 after dismantling costs. The marketing
department estimates that the automakers will get the contract at a price of $230
per ton. The engineering department estimates you will need an initial net
working capital investment of $450,000. You require a 13 percent return and face
a marginal tax rate of 38 percent on this project. (20 points)
a. What is the estimated operating cash flow for this project?
OCF= ((230-200)(35000)-300,000)(1-.38)+300,000(.38)=579,000
b. What is the NPV? Is the project acceptable?
CF0=-1,500,000-450,000=-1,950,000
CF(SV)=500,000-(500,000-0)(.38)=310,000
CF1=CF2=CF3=CF4=579,000, CF5=1,339,000
NPV=498,974.45 YES
c. What is the accounting breakeven quantity?
Q=(300,000+300,000)/(230-200)=20,000
d. What is the financial breakeven quantity?
NPV = 0=-1,950,000+OCF*PVIF+760,000PVIF;(PV=-1,950,000, I=13,
n=5,FV=760,000, PMT=?=OCF); OCF = 437,134.31
437,134.31=[30Q-300,000](1-.38)+300,000(.38); Q=27,372.81
6. Taylor Enterprises has 12,000 bonds outstanding that have a 6% coupon rate. The bonds
are selling at 98% of face value ($1,000), pay interest semi-annually, and mature in 28
years. The bonds are yielding 6.15%. There are 400,000 shares of 9% preferred stock (par
value $100) outstanding with a current market price of $83 a share. In addition, there are
1.40 million shares of common stock outstanding with a market price of $54 and a beta of
1.2. The firm’s marginal tax rate is 34%. The overall stock market is yielding 12% and
the U.S. Treasury bill rate is 4.0%. (20 points)
a. What is the cost of equity?
Rs = 4+1.2(12-4)=13.6%
b. What is the cost of financing using preferred stock?
Rp=9/83=10.84%
c. What is the pre-tax cost of debt financing?
6.15% (given)
d. What is the weighted average cost of capital?
S=54*1,400,000=75,600,000
P=83*400,000=33,200,000
B=980*12000=11,760,000
S+B+P=120,560,000
WACC = .6271(13.6)+.2754(10.84)+0.0975(6.15)(1-.34)=11.91%
7. Give the following data answer the questions below:
Economic
State
Stagnant
Slow growth
Average
Rapid growth
Probability of
State
0.20
0.35
0.30
0.15
Return on
Market
-10%
10%
15%
25%
Return on
Dallas Inc.
-15%
15%
25%
35%
Risk-free
Rate
3%
3%
3%
3%
a. Calculate the expected returns on the stock market and on Dallas Inc. stock. (10
points)
E(Rm)=9.75%; E(Rd)=15%
b. What is the variance of the market? (5 points)
Variance = 121.1876
c. What is the standard deviation of a portfolio invested 50% in the market and 50% in
the risk free asset? (5 points)
Variance = .52(121.1876) = 30.2969; Std Dev = 5.5043%
d. What is Dallas Inc.’s beta? (5 points)
Covariance (Rm, Rd) = 180; Beta = 180/121.1876 = 1.4853
e. What is Dallas Inc.’s required return according to the CAPM? (5 points)
Rd=3+1.4853(9.75-3)=13.0258%