Show your work. The first 7 questions are worth 5 points each.

1.  Which form of the efficient market hypothesis implies that security prices reflect all information contained in past prices? Weak

  1. Holden Bicycles has 1,000 shares outstanding each with a par value of $0.10 each. If they are sold to shareholders at $19 each, what would the capital surplus be? $18,900
  2. You own 1,000 shares of a stock. You can cast your 1,000 votes for a single director. What kind of voting does the stock have? Straight

4.  You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in dividends, and your stock was worth $2,500 total. What was your total percentage return? (2500+400-2000)/2000 = 45%

5.  The beta of stock A is 0.70. The risk-free rate is 5 percent, and the market risk premium is 8.5 percent. Assume the capital-asset-pricing model holds. What is the expected return on stock A? E(RA) – 5 +0.7(8.5)=10.95%

6.  Suppose Garageband.com has a 28 percent cost of equity capital and a 10% before tax cost of debt capital. The firm’s debt-to-equity ratio is 1.0. The tax rate is 30 percent. What is the firm’s WACC? WACC = .5(10(1-.3)+.5(28)=17.5%

7.  Suppose that we have identified three important systematic risk factors given by exports, inflation and industrial production. In the beginning of the year, growth in these three factors is estimated at -1%, 2.5% and 3.5% respectively. However, actual growth in these factors turns out to be 1%, -2% and 2%. The factor betas are given by βEX = 1.8, βI = 0.7 and βIP = 1.0. If the expected return on the stock is 6% and no unexpected news concerning the stock surfaces, calculate the stock’s total return. R = 6+1.8(1-(-1)) + .7(-2-2.5)+1(2-3.5) = 4.95%

  1. Give the following information: (15 points)

Security / Return / Standard Deviation / Beta
A / 16% / 25% / 0.8
B / 12% / 20% / 1.2
Risk-free asset / 4%
  1. Which of A and B has the least total risk? The least systematic risk?

A has the least systematic and B has the least total.

b.  What is the value of the systematic risk for a portfolio with 2/3 of the funds invested in A and 1/3 of the funds invested in B? 2/3(0.8)+1/3(1.2)=0.93

  1. What is the portfolio expected return and the portfolio beta if you invest 35% in A, 45% in B and 20% in the risk-free asset?

E(R)= .35(16)+.45(12)+.2(4)=11.8%; β = .35(0.8)+.45(1.2) + .2(0) = 0.82

  1. Ribuck has purchased a new machine to produce its new line of shoes. The machine has an economic life of five years. The depreciation schedule for the machine is straight-line with no salvage value. The machine costs $300,000. The sales price of a pair of shoes is $60. Variable costs are $8 per pair and fixed costs are $100,000. Assume that the corporate tax rate is 34 percent and the appropriate discount rate is 8 percent. What is the present value break-even point? (10 points) In calculator PV = 300,000, i=8, n=5, PMT = ? = 75,136.94 = OCF.

D = 300,000/5=60,000; OCF = (60Q-8Q-100,000)(1-.34)+60,000(.34) and solve for Q = 3,518.

  1. Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill skiing facility, while DS is a tour company that specializes in walking tours and camping. The equally likely returns on each company over the next year are expected to be: (20 points)

Economy / Idaho Slopes / Dakota Steppes / Portfolio
Strong Downturn / -10% / 2% / -4%
Slow Growth / 4% / 6% / 5%
Strong Growth / 20% / 4% / 12%
Mean / 4.67% / 4% / 4.33%
Variance / 150.22 / 2.67 / 42.889
  1. What are the means of IS and DS? (see above)
  2. What are the variances of IS and DS? (see above)
  3. What is the covariance between the IS and DS returns?

Cov=1/3[(-10-4.67)(2-4)+(4-4.67)(6-4)] = 9.333

  1. If IS and DS are combined in a portfolio with 50% invested in each, what are the expected return and standard deviation of the portfolio?

E(R) = .5*4.67+.5*4 = 4.33%

Var = .52(150.22) + .52(2.67)+ 2(.5)(.5)(9.33) = 42.89

Standard Deviation = 6.55%

These can be done using the table above or from parts a, b, and c.

  1. The current market rate of return is 11% and the risk-free rate is 4%. You have been given the job of determining your firm’s cost of capital components. The company has 10 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The β of the equity is 1.5 and the tax rate is 30%. (20 points)

a.  What is the market value of the firm? Equity/.7 = $321,428,571.43

b.  What is the market value of the debt? Firm – Equity = $96,428,571.43

c.  What is the market value of the equity? 10,000,000*22.5 = $225,000,000

d.  What is the required rate of return on equity? R = 4 +1.5(11-4)=14.5%

e.  What is the cost of debt to the firm? 12%