Question

1) Zelo, inc. Stock has beta of 1.5. The risk free rate of return is 5% and the market rate of return is 10%. What is the amount of the risk Premium on zelo Stock?

A) 5%

B) 10%

C)7.5%

D) 12.5%

2) You want your portfolio beta to be 1.20. Currently, your portfolio consists of $100 ivnested in stock A with a beta of 1.4 and $300 in stock B with a beta of .6. You have another $400 to invest and want to divide it between an asset with a beta of 1.6 and a risk free asset. How much should you invest in the risk-free asset?

A) 320

B) 200

C) 0

D)560

3) which of the following statements is incorrect convering the equity component of the WACC?
A) there is a tax sheild such as with debt.

B) Preferred equity has a separate component

C) market values should be used in the calculations

D) The value of retained earning is not included.

TIA and please explain or show work.

Answer 1

1)

The risk premium is an extra return received by an investor by investing in a scrip with high risk other than a risk-free rate of return

the risk-free rate of return = 5% (Rf)

the market rate of return = 10% (Rm)

Risk premium = Rm- Rf

= 10%-5%

= 5%

2)

stock A = 100$

stock B = 300$

risk free asset + stock c = 400$

the total investment value of the portfolio is 800$ which has to maintain a total beta value of 1.2 for the entire portfolio

beta value for stock A = 1.4

beta value for stock B = .6

for stock C beta value = 1.6

1.20= (100/800)*1.4+(300/800)*.6+x*1.6

1.20 = .125*1.4+3.75*.6+1.6x

1.20 = .175+.225+1.6x

1.20 = 0.4+1.6x

1.20 -0.4 =1.6x

0.8=1.6x

0.8/1.6=x

X=0.5

that is x=50%

so the total amount that goes into the risk-free asset is "ZERO" (0)

it can be cross-checked through the following method and the total value of beta should remain 1.20

1.20= 100/800*1.4+300/800*.6+400/800*1.6

1.20= .175+.225+0.8

1.20=1.20

hence the total investment into risk free assset remains zero(0)

3)

a) the tax sheild with debt is included in the calculation of wacc equity component. gebnerally the benefit of taking debt is to reduce the taxable portion of the profits

b) prefered equity has to be shown separately while calculating the WACC of equity

c) the market values are considered as they reflect the actual position

d) the value of the retained earnings is included in the calculation of WACC of equity.

since retained earnings are also part of firms equity capital they are considered in calculating WACC of the equity component

hence option D is the incorrect statement