Question

1. Suppose you observe the following situation:

	Standard Deviation	Beta	Expected Return
Stock A	33%	1.2	0.13
Stock B	38%	0.8	0.12
Stock C	30%	1.1	0.11
T-Bill	-	-	0.03 + 0.5×9

Which one(s) has the highest systematic risk? (Stock A, Stock B, Stock C, Hard to Say)    

Which one(s) has the highest unsystematic risk? (Stock A, Stock B, Stock C, Hard to Say)  

If Stock C is correctly priced, what is the reward-to-risk ratio (Sharpe ratio) for Stock A and B? Are Stock A and B under-priced?

Reward-to-risk ratio (Company A):

Reward-to-risk ratio (Company B):

Is Company A underpriced?

Is Company B underpriced?

b. Given the following information for Company D, find the WACC. Assume the company’s tax rate is 20 percent.

1. Debt: 6,500 5 percent coupon bonds outstanding, $1,000 par value, 3 years to maturity, selling for (101+9) percent of par; the bonds make semiannual payments.
2. Common stock: 300,000 shares outstanding, selling for $52 per share; the beta is 0.95.
3. Preferred stock: 20,000 shares of 6 percent preferred stock outstanding, currently selling for $98 per share.
4. Market: 6 percent market risk premium and 2 percent risk-free rate.

Answer 1

a]
1]	Stock A has the highest systematic risk [Highest beta]
2]	Stock B has the highest unsystematic risk [Highest SD]
3]	Reward to risk ratio of C = (11-3)/30 =	0.2667
4]	Required return from A = 3%+33%*0.2667 =	11.80%
	As the expected return of A is higher, it is underpriced.
5]	Required return from B = 3%+38%*0.2667 =	13.13%
	As the expected return of B is higher, it is overpriced.
b]
1]
a]	Before tax cost of debt = YTM
	YTM using a calculator = 1.57%
	[Inputs for YTM calculator are: Price $1100, Face value $1000,
	Yrs to maturity 3 years, coupon rate 5% & coupon payment
	frequency 2]
	After tax cost of debt = 1.57%*(1-20%) =	1.26%
b]	Cost equity per CAPM = 2%+0.95*6% =	7.70%
c]	Cost of preferred stock = 6/98 =	6.12%
d]	WACC is calculated below:
	Component of Capital	Market Value	Weight	Component Cost	Weight
	Debt [6500*1100]	$         7,150,000	28.94%	1.26%	0.36%
	Preferred stock [20000*98]	$         1,960,000	7.93%	7.70%	0.61%
	Common stock [300000*52]	$       15,600,000	63.13%	6.12%	3.87%
	Total	$       24,710,000			4.84%
	WACC = 4.84%