Zetta Company has unleveraged beta 1.3, risk free rate 7% and market risk premium for 5%. The applicable tax rate is 40%. The company needs to finance its new project under two different scenarios.

Scenario Debt ratio Interest rate EPS
1 0% 0% $2.40
2 30% 10% $3.40

6. WACC under scenario number 2 equals to *

a)12.42%

b)11.55%

c)13.50%

d)14.24%

e)None of the above

7. The price per share under scenario number 2 equals to *

a)$28.50

b)$26.50

c)$24.30

d)$22.40

e)None of the above

8. Which of the following statements is correct? *

a)The optimal capital structure refers to the debt ratio that can minimize the WACC and maximize the share price.

b)The optimal capital structure refers to the debt ratio that can maximize the WACC and minimize the share price.

c)The optimal capital structure refers to the debt ratio that can maximize the WACC and maximize the share price.

d)The optimal capital structure refers to the debt ratio that can minimize the WACC and minimize the share price.

e)None of the above

Zetta Company has unleveraged beta 1.3, risk free rate 7% and market risk premium for 5%. The applicable tax rate is 40%. The company needs to finance its new project under two different scenarios.

Scenario Debt ratio Interest rate EPS
1 0% 0% $2.40
2 30% 10% $3.40

6. WACC under scenario number 2 equals to *

a)12.42%

b)11.55%

c)13.50%

d)14.24%

e)None of the above

7. The price per share under scenario number 2 equals to *

a)$28.50

b)$26.50

c)$24.30

d)$22.40

e)None of the above

8. Which of the following statements is correct? *

a)The optimal capital structure refers to the debt ratio that can minimize the WACC and maximize the share price.

b)The optimal capital structure refers to the debt ratio that can maximize the WACC and minimize the share price.

c)The optimal capital structure refers to the debt ratio that can maximize the WACC and maximize the share price.

d)The optimal capital structure refers to the debt ratio that can minimize the WACC and minimize the share price.

e)None of the above

Question 5 (25 marks / Risk, Return and CAPM)
(Each of the following parts is independent.)
(a) According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market portfolio (m) and 60% of Treasury bills (i.e. risk-free asset)? Assume the risk-free rate is 3% and the market risk premium is 7%?  

(b) You are considering investing in the following two stocks. The risk-free rate is 7 percent and the market risk premium is 8 percent.

Stock ,Price Today , Expected Price in 1 year, Expected Dividend in 1 year, Beta
X $20 $22 $2.00 1.0
Y $30 $32 $1.78 0.9

i) Compute the expected and required return (using CAPM) on each stock.   
ii) Which asset is worth investing? Support your answer with calculations.     

(c) Which pair of stocks used to form a 2-asset portfolio would have the greatest diversification effect for the portfolio? Briefly explain.
                   
                            Correlation
Stocks A & B            -0.66
Stocks A & C            -0.42
Stocks A & D                0
Stocks A & E               0.75
         
(d) Explain the terms systematic risk and unsystematic risk and their importance in determining investment return.          

(Each of the following parts is independent.)

1. According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market portfolio (m) and 60% of Treasury bills (i.e. risk-free asset)?  Assume the risk-free rate is 3% and the market risk premium is 7%?

2. You are considering investing in the following two stocks. The risk-free rate is 7 percent and the market risk premium is 8 percent.

1. Compute the expected and required return (using CAPM) on each stock.
2. Which asset is worth investing? Support your answer with calculations.

3. Which pair of stocks used to form a 2-asset portfolio would have the greatest diversification effect for the portfolio? Briefly explain.

(d)   Explain the terms systematic risk and unsystematic risk and their importance in determining investment return.

Please provide stepping for all if possible, much appreciated.

Question 5 (25 marks / Risk, Return and CAPM) (Each of the following parts is independent.) (a) According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market portfolio (m) and 60% of Treasury bills (i.e. risk-free asset)? Assume the risk-free rate is 3% and the market risk premium is 7%? ​​​​ (b) You are considering investing in the following two stocks. The risk-free rate is 7 percent and the market risk premium is 8 percent. Stock Price Today Expected Price in 1 year Expected Dividend in 1 year Beta X $20 $22 $2.00 1.0 Y $30 $32 $1.78 0.9 i) Compute the expected and required return (using CAPM) on each stock. ii) Which asset is worth investing? Support your answer with calculations. (c) Which pair of stocks used to form a 2-asset portfolio would have the greatest diversification effect for the portfolio? Briefly explain. Correlation Stocks A & B -0.66 Stocks A & C -0.42 Stocks A & D 0 Stocks A & E 0.75 ​​​​​​​​​​​ (d)​Explain the terms systematic risk and unsystematic risk and their importance in determining ​investment return.​​​​​​

The Carolina Cougars is a major league baseball expansion team beginning its third year of operation. The team had losing records in each of its first 2 years and finished near the bottom of its division. However, the team was young and generally competitive. The team’s general manager, Frank Lane, and manager, Biff Diamond, believe that with a few additional good players, the Cougars can become a contender for the division title and perhaps even for the pennant. They have prepared several proposals for free- agent acquisitions to present to the team’s owner, Bruce Wayne.

Under one proposal the team would sign several good available free agents, including two pitchers, a good fielding shortstop, and two power-hitting outfielders for $52 million in bonuses and annual salary. The second proposal is less ambitious, costing $20 million to sign a relief pitcher, a solid, good-hitting infielder, and one power-hitting out- fielder. The final proposal would be to stand pat with the current team and continue to develop.

General Manager Lane wants to lay out a possible season scenario for the owner so he can assess the long-run ramifications of each decision strategy. Because the only thing the owner understands is money, Frank wants this analysis to be quantitative, indicating the money to be made or lost from each strategy. To help develop this analysis, Frank has hired his kids, Penny and Nathan, both management science graduates from Tech.

Penny and Nathan analyzed league data for the previous five seasons for attendance trends, logo sales (i.e., clothing, souvenirs, hats, etc.), player sales and trades, and revenues. In addition, they interviewed several other owners, general managers, and league officials. They also analyzed the free agents that the team was considering signing.

Based on their analysis, Penny and Nathan feel that if the Cougars do not invest in any free agents, the team will have a 25% chance of contending for the division title and a 75% chance of being out of contention most of the sea- son. If the team is a contender, there is a .70 probability that attendance will increase as the season progresses and the team will have high attendance levels (between 1.5 million and 2.0 million) with profits of $170 million from ticket sales, concessions, advertising sales, TV and radio sales, and logo sales. They estimate a .25 probability that the team’s attendance will be mediocre (between 1.0 million and 1.5 million) with profits of $115 million and a .05 prob- ability that the team will suffer low attendance (less than 1.0 million) with profit of $90 million. If the team is not a contender, Penny and Nathan estimate that there is .05 probability of high attendance with profits of $95 mil- lion, a .20 probability of medium attendance with profits of $55 million, and a .75 probability of low attendance with profits of $30 million.

If the team marginally invests in free agents at a cost of $20 million, there is a 50–50 chance it will be a contender. If it is a contender, then later in the season it can either stand pat with its existing roster or buy or trade for players that could improve the team’s chances of winning the division. If the team stands pat, there is a .75 probability that attendance will be high and profits will be $195 million. There is a .20 probability that attendance will be mediocre with profits of $160 million and a .05 probability of low attendance and profits of $120 million. Alternatively, if the team decides to buy or trade for players, it will cost $8 million, and the probability of high attendance with profits of $200 million will be .80. The probability of mediocre attendance with $170 million in profits will be .15, and there will be a .05 probability of low attendance, with profits of $125 million.

If the team is not in contention, then it will either stand pat or sell some of its players, earning approximately $8 million in profit. If the team stands pat, there is a .12 probability of high attendance, with profits of $110 million; a .28 probability of mediocre attendance, with profits of $65 million; and a .60 probability of low attendance, with profits of $40 million. If the team sells players, the fans will likely lose interest at an even faster rate, and the probability of high attendance with profits of $100 million will drop to .08, the probability of mediocre attendance with profits of $60 million will be .22, and the probability of low attendance with profits of $35 million will be .70.

The most ambitious free-agent strategy will increase the team’s chances of being a contender to 65%. This strategy will also excite the fans most during the off-season and boost ticket sales and advertising and logo sales early in the year. If the team does contend for the division title, then later in the season it will have to decide whether to invest in more players. If the Cougars stand pat, the probability of high attendance with profits of $210 million will be .80, the probability of mediocre attendance with profits of $170 million will be .15, and the probability of low attendance with profits of $125 million will be .05. If the team buys players at a cost of $10 million, then the probability of having high attendance with profits of $220 million will increase to .83, the probability of mediocre attendance with profits of $175 million will be .12, and the probability of low attendance with profits of $130 million will be .05.

If the team is not in contention, it will either sell some players’ contracts later in the season for profits of around $12 million or stand pat. If it stays with its roster, the prob- ability of high attendance with profits of $110 million will be .15, the probability of mediocre attendance with profits of $70 million will be .30, and the probability of low attendance with profits of $50 million will be .55. If the team sells players late in the season, there will be a .10 probability of high attendance with profits of $105 million, a .30 probability of mediocre attendance with profits of $65 mil- lion, and a .60 probability of low attendance with profits of $45 million.

Assist Penny and Nathan in determining the best strategy to follow and its expected value.

The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a marginal tax rate of 40 percent) is

Select one:

a. 4.41 percent.

b. 5.15 percent.

c. 7 percent.

d. 7.35 percent.

A corporation is trying to raise money for a business expansion. The total cost of the expansion is $1,000,000. The expected return on assets before taxes of the business expansion project is 10% on the total asset investment. (Expected probabilities of returns are .25 of an 8% return, .5 of a 10% return and .25 of a 12% return.)

After the privately held corporation owners are considering two options which involve obtaining one of two types of loans from an area bank. The current individual stock investors will put in the needed additional equity investment capital for the expansion project.

Loan option 1: The bank is willing to lend 60% of the $1,000,000 project with a 7 year interest only loan at an annual contract rate of 8% with interest payable quarterly and a balloon note payment at the end of 7 years. The loan closing costs will be 4% of the amount borrowed and the owners will be held personally responsible for the loan. The closing costs fees must be paid in cash when the loan contract is signed and begins.

Loan option 2: The bank is also willing to lend 70% of the $1,000,000 project with a 7-year interest only loan at an annual contract rate of 9% with interest payable quarterly and a balloon note payable at the end of 7 years. The loan closing cost is 5% of the amount borrowed and the owners will also be held personally responsible for the loan. The set up fees must be paid in cash when the loan contract is signed and begins.

To assist in this financial decision making situation, calculate the follow:

What is the APR for each loan?  

Option 1 _________                      

Option 2 ___________

If Option 2 is selected, what is the incremental cost of borrowing the additional amount of money?

Incremental Cost of Borrowing ________________%

What is the expected return on investment for this business expansion project for each option of financing this expansion project?

ROE if Option 1 is used? __________                                      

ROE if Option 2 is used? ___________________

Which option do you recommend and why?  

Comprehensive Insurance Company has two product lines: health insurance and auto insurance. The two product lines are served by three operating departments which are necessary for providing the two types of products: claims processing, administration, and sales. These three operating departments are supported by two departments: information technology and operations. The support provided by information technology and operations to the other departments is shown below.

The total costs incurred in the five departments are:

Required:

Determine the total costs in each of the three operating departments, after departmental allocations, using (a) the direct method, (b) the step method (first for information technology going first in the allocation and then for operations going first), and (c) the reciprocal method. (Round percentage calculations to 4 decimal places (e.g., 33.3333%). Do not round your intermediate calculations. Round your final answers to nearest whole dollar amount.)