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unit 10-11 mini review solutions.docx

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Department
Administrative Studies
Course
ADMS 3530
Professor
Lois King
Semester
Winter

Description
Unit 10 (CAPM) and Unit 11 (WACC0 – Mini Review – SOLUTIONS 1. Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the market risk premium is 6%? Stock A B C Beta 1.25 0.80 1.06 Expected Return 12.60% 8.80% 11.20% A) A only B) B only C) C only D) A and C only E) A, B, and C Answer: D A: E(r) = 4% + 1.25(6%) = 11.50% < 12.60% B: E(r) = 4% + 0.80(6%) = 8.80% = 8.80% C: E(r) = 4% + 1.06(6%) = 10.36% < 11.20% 2. You own two risky assets, both of which plot on the security market line. Asset A has an expected return of 12% and a beta of 0.8. Asset B has an expected return of 18% and a beta of 1.4. If your portfolio beta is the same as the market portfolio, what proportion of your funds are invested in asset A? A) 0.33 B) 0.50 C) 0.67 D) 1.33 E) 1.67 Answer: C 1= 0.8A + (1 – A)1.4; A = 0.67 3. Suppose that two firms, A and B, are considering the same project which has the same risk as firm B's overall operations. The project has an IRR of 14.0%. Firm A has a beta of 1.4, while firm B's beta is 1.1. If the risk-free rate is 5.25% and the market risk premium is 7.0%, which firm(s) should take the project? A) A only B) B only C) Both A and B D) Neither A nor B E) Cannot be determined without additional information Answer: C A: r = 5.25% + 7%(1.1) = 12.95% < IRR = 14%; same risk as Firm B B: r = 5.25% + 7%(1.1) = 12.95% < IRR = 14% 4. A stock with a beta of 1.2 now sells for $40. Investors expect the stock to pay a year-end dividend of $2.00. The T-bill rate is currently 3% and the market risk premium is 7%. If the stock is fairly priced today, what must be investors' expectations for the price of the stock at the end of the year? a) $42.56 b) $44.00 c) $44.56 d) $46.00 Answer: A From the CAPM: r = r +β (r - r) => r = 3% + 1.2*(7%) = 11.4% e f m f e r = 0.114 = DIV + Cap Gain = 2 + (P 1 - 40) e P0 40 P = $42.56 1 5. Richbay Audio Shop has a cost of debt of 7 percent, a cost of equity of 11 percent, and a cost of preferred stock of 8 percent. The firm has 104,000 shares of common stock outstanding at a market pr
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