Question

Q1/Given the following information about the returns of stocks A, B, and C, what is the expected return of a portfolio invested 30% in stock A, 40% in stock B, and 30% in stock C?

State of economy	Probability	Stock A	Stock B	Stock C
Boom	0.15	0.24	0.31	0.23
Good	0.21	0.19	0.14	0.12
Poor	0.25	0.01	0.08	0.04
Bust	--	-0.29	-0.16	-0.19

Enter answer in percents.

Q2/GIMP Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 2 years to maturity that is quoted at 109.9 percent of face value. The issue makes annual payments and has an embedded cost (coupon rate) of 8.8 percent annually. What is the firm's pretax cost of debt? (Enter answer in percents.)

Answer 1

	Expected Return on stocks =
	State	Prob.	A	B	C	P x A	P x B	P x C
	Boom	0.15	24	31	23	3.6	4.65	3.45
	Good	0.21	19	14	12	3.99	2.94	2.52
	Poor	0.25	1	8	4	0.25	2	1
	Bust	0.39	-29	-16	-19	-11.31	-6.24	-7.41
		1.00				-3.47	3.35	-0.44
	Stock	Weight	Return	W x R
	A	0.3	-3.47	-1.041
	B	0.4	3.35	1.34
	C	0.3	-0.44	-0.132
				0.167
	Expected return on portfolio =	0.167
Q2)	Cost of Debt =		YTM of BOND x (1- Tax Rate)
	YTM is the rate at which price of bond if discounted is = PV cashflows of bond
	Coupon =	1000 x 8.8% =		88
	No. of payments =			2
	Selling price =	1000 x 109.9% =		1099
	1099	=	88 x PVAF(YTM,2) + 1000 x PVIF(YTM,2)
	YTM			Price
	3%			1110.981
	YTM			1099		-11.9812
	4%			1090.533		-20.4487
						0.585917
	Using linear Interpolation -
	YTM-3/4-3 =		1099-1110.981/1090.533-1110.981
	YTM -3 =		0.585917
	YTM =		3.585917
	Pre tax cost of debt =		3.585917