Skyline University College MBA Program Financial Management –Fall 2017 Class Par

Question

Skyline University College
MBA Program

Financial Management –Fall 2017 Class Participation- 10 marks
Name:
Note: write the formula for all your answers and show all the calculations.
Question 1: (5 marks)
Consider the following information about three stocks:
State of Economy Probability of State of Economy Rate of Return if State Occurs
Stock A Stock B Stock C
Boom 0.35 0.24 0.36 0.55
Normal 0.50 0.17 0.13 0.09
Bust 0.15 0.00         - 0.28        - 0.45

1. If your portfolio is invested 40 percent each in stock A and B and 20 percent in stock C, calculate the following:
a. The portfolio expected return?
b. The portfolio Standard Deviation.
2. If the expected T-bill (risk free) rate is 3.8 percent, what is the expected risk premium on the portfolio?
Question 2: (5 marks)
Given the following information for Even-flow Power Co:
Debt:
8,000 6.5 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 92 percent of par; the bonds make semiannual payments.

Common Stock:
250,000 shares outstanding, selling for $27 per share, the beta is 1.05.

Preferred Stock:
15,000 shares of 5 percent preferred stock outstanding, currently selling for $93 per share

Market:
8 percent market risk premium and 4.5 percent risk-free rate.

Calculate the Weighted Average Cost of Capital (WACC), assuming the company’s tax rate is 35 percent.

plz help me to find answers for questions

Explanation / Answer

Question 1:

Expected returns of Stock A=0.35*0.24+0.5*0.17+0.15*0=16.9%

Expected returns of Stock B=0.35*0.36+0.5*0.13+0.15*-0.28=14.9%

Expected returns of Stock C=0.35*0.55+0.5*0.09+0.15*-0.48=16.6%

Portfolio return=40%*16.9%+20%*14.9%+20%*16.6%=13.1%

Standard deviation of A=sqrt(0.35*(0.24-0.169)^2+0.24*(0.17-0.169)^2+0.15*(0-0.169)^2)=7.7774%

Standard deviation of B=sqrt(0.35*(0.36-0.149)^2+0.24*(0.13-0.149)^2+0.15*(-0.28-0.149)^2)=20.8%

Standard deviation of C=sqrt(0.35*(0.55-0.166)^2+0.24*(0.09-0.166)^2+0.15*(-0.45-0.166)^2)=33.2%

Risk premium=13.1-3.8=9.3%

Question 2:
920=32.5/(1+y/2)+32.5/(1+y/2)^2………….32.5/(1+y/2)^40+1000/(1+y/2)^40

So, y=7.2647%

Pre-tax cost of debt=7.2647%
after-tax cost of debt=7.2647*(1-35%)=4.722%

Market value of debt=8000*1000*0.92=7360000

Market value of stock=250000*27=6750000

Market value of preferred stock=15000*93=1395000

Proportion of debt=7360000/(7360000+6750000+1395000)=0.474685

Proportion of stock=6750000/(7360000+6750000+1395000)=0.435343

Proportion of preferred stock=1395000/(7360000+6750000+1395000)=0.089970977

Cost of preferred stock=5%

Cost of equity=4.5+1.05*8=12.9

WACC=0.435343*12.9%+0.474685*4.722%+0.089970977*5%=8.3%

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