Finance Questions

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 =