Assume the following information for two stocks, A and B, and a risk-free asset.

(a) Suppose you have a portfolio with investment of $200 in stock A, $400 in stock B, and $400 in the risk-free asset. Compute the expected return and standard deviation of this portfolio.

(b) Consider a portfolio that consists of only stocks A and B (but not the risk-free asset). If the expected return of this portfolio is 8%, what is the amount invested in Stock A?

(c) Explain why investing in a portfolio with both Stocks A and B is more preferable than investing in either Stock A, or Stock B only. Provide TWO reasons.

(d) Suppose the market portfolio return is 8%. Draw the security market line (SML) on a graph with clear labels on X and Y axis. You must plot the values of the equation of the line on the axis.

(e) Determine where Stock A and Stock B lies on the graph of SML and whether they are correctly priced, underpriced or overpriced.

The CFO of a manufacturing firm is determining the capital budget. Currently the market value of the firm' equity and debt are $4 billion and $12 billion, respectively. The company’s debt trades with a yield to maturity of 8%, and its equity has an expected return of 14%. The firm’s marginal tax rate is 30%.

The projects that are under consideration have different risk and returns. The company estimates that low-risk projects have a cost of capital of 8% and high-risk projects have a cost of capital of 18%.

Project                  Expected Return                   Risk

A 16% High

B 12% Average

C 10% Low

D 9% Low

E 6% Low

(a) Compute the company’s weighted average cost of capital (WACC).

(b) The Finance Manager suggests to invest only in projects which expected rate of returns are higher than the firm’s WACC. Do you agree with the Finance Manager? Justify your answers with reference to the use of WACC.

(c) To maximize shareholder wealth, which of the projects should the CFO select to invest in? Evaluate each project separately and provide the justification.

The CFO of a manufacturing firm is determining the capital budget. Currently the market value of the firm' equity and debt are $8 billion and $10 billion, respectively. The company’s debt trades with a yield to maturity of 8%, and its equity has an expected return of 14%. The firm’s marginal tax rate is 30%.

The projects that are under consideration have different risk and returns. The company estimates that low-risk projects have a cost of capital of 8% and high-risk projects have a cost of capital of 14%.

Project                Expected Return                   Risk

A 15% High

B 13% Average

C 12% High

D 10% Low

E 7% Low

(a) Compute the company’s weighted average cost of capital (WACC).

(b) The Finance Manager suggests to invest in projects which expected rate of returns are higher than the firm’s WACC. Do you agree with the Finance Manager? Justify your answers with reference to the use of WACC.

(c) To maximize shareholder wealth, which of the projects should the CFO select to invest in? Evaluate each project separately and provide the justification.

Currently a three-year zero-coupon treasury bond is traded at a price of $70.38. The Treasury plans to issue a three-year annual coupon bond, with a coupon rate of 10%. The face value of all treasury annual coupon bonds is $100.

(a) What is the yield to maturity of the three-year zero-coupon bond?

(b) At what price should the three-year coupon bond be selling for?

(c) A bond analyst comments that without calculation, he can infer whether the bond will sell above its face value or not. How can he do this? Provide a brief explanation.

(d) If two bonds have the same term to maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price." Do you agree that this is correct? Provide a brief explanation.

(e) Lily manages a bond portfolio with the following Treasury bonds:

• 3 year zero-coupon bonds
• 3 year 10% coupon bonds
• 10 year zero-coupon bonds
• 10 year 10% coupon bonds

She believes that market interest rates are going to increase over the next several months. Accordingly, she is suggested to do the following. Comment on each suggestion and make your recommendations to Lily (e.g., whether or not to adopt the suggestion).

1. Sell the 3 year zero coupon bonds and buy the 10 year zero coupon bonds
2. Buy the 10 year zero coupon bonds and sell the 10 year 10% coupon bonds

What factors should a jurisdiction consider in setting debt policies?

AFN equation

Broussard Skateboard's sales are expected to increase by 15% from $8.2 million in 2016 to $9.43 million in 2017. Its assets totaled $5 million at the end of 2016. Broussard is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2016, current liabilities were $1.4 million, consisting of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of accruals. The after-tax profit margin is forecasted to be 5%, and the forecasted payout ratio is 60%. Use the AFN equation to forecast Broussard's additional funds needed for the coming year. Round your answer to the nearest dollar. Do not round intermediate calculations.

1. Discuss Modigliani and Miller's Propositions I in a world with corporate tax but no other market frictions nor distress costs. List the basic assumptions, results, and intuition of the model.

Based on this model, if the original unlevered firm value is $100 million, the corporate tax rate is 20%, and the CFO is planning to carry out a leveraged recapitalization to add a permanent debt of $30 million. The interest rate for the debt is 6% for the coming year. The unlevered equity requires 10% annual return. What’s the levered firm value? What’s the value of levered equity?

1. How to calculate the free cash flow of the firm (also referred to as the firm’s free cash flow) directly? How to calculate the firm’s free cash flow from earnings in a levered firm? What is the appropriate discount rate for the firm’s free cash flow if the firm plans to have a constant debt-to-equity ratio forever? What do you get when you calculate the present value of the free cash flow of the firm in this case? What is the appropriate discount rate for the firm’s free cash flow if the firm plans to have debt only for 5 years and the interest payment varies over years? What do you get when you calculate the present value of the free cash flow of the firm using this discount rate?

Describe how to estimate the free cash flow to equity in a levered firm starting from the firm’s free cash flow as we discussed in class. What is the right discount rate for the free cash flow to equity? What do you get when you calculate the present value of the free cash flow to equity? What’s the difference between the free cash flow of the firm and the free cash flow to equity?

An energy farm invests in solar panels with installation costs of $2 million today. The farm expects to have net inflows of $60,000 a year for the next 20 years and $50,000 a year for 20 years after that (total of 40 years). Calculate the payback, IRR, and NPV for the solar panels. Assume a discount rate of 4.3%.

1. Discuss Modigliani and Miller's Propositions I and II in a perfect world without taxes nor distress costs. List the basic assumptions, results, and intuition of the model. Based on this model, if the original unlevered firm value is $100 million and the CFO is planning to carry out a leveraged recapitalization to a debt equity ratio of 1:1. What’s the levered firm value? If the unlevered equity requires 10% annual return and the debt requires a 6% of annual return, what’s the required return for the levered equity?

Calculate the mean and variance of the following cash flows.

A 20% probability of making $100, a 30% probability of making $200, a 10% probability of making $500, and a 40% probability of losing $50

Explain how to estimate the cost of capital. In particular, explain how to estimate the equity cost of capital, list two different methods to estimate the debt cost of capital, and how to calculate the weighted average cost of capital for a given debt-equity ratio.

It is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Foreign exchange risk can be divided into three main categories: transaction exposure, translation exposure, and economic exposure. Talk about some ways that risk in these three areas can be minimized.

Please answer only with BA2 PLUS Financial calculator

An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air pollution. The company could spend an additional $40 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would cost $239.99 million, and the expected net cash inflows would be $80 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $85.19 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk-adjusted WACC is 17%.
a) Calculate the NPV and IRR with and without mitigation.
b) How should the environment effects be dealt with when evaluating this project?
c) Should this project be undertaken? If so, should the firm do the mitigation?

An investor buys a condo for $160,000 by putting 10% down and financing the rest using the 15 year fixed rate in the WSJ. What are her monthly payments? Another investor decides to use an interest only loan to finance the same type of condo, the rate is 3.5% a year, what are the monthly payments? Three years later the condo is worth $170,000, what will be the return on the investment for each investor?