Week 4 Assignment 4 MGM 6620 Managerial Finance Professor: Manuel V. Sicre Student Name: Zoraya Sandoval 01/28/2012 Chapter #11 11. 1Diversifiable and Nondiversifiable Risks. In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk? Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unsystematic portion of the total risk can be eliminated at little cost.
On the other hand, there are systematic risks that affect all investments. This portion of the total risk of an asset cannot be lavishly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns. 11. 5 Expected Portfolio Returns. If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer.
The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return. Questions and Problems (QP) 11. 1, 11. 4, 11. 8 & 11. 13 11. 1 Determining Portfolio Weight. What are the portfolio weights for a portfolio that has 90 shares of Stock A that sell for $84 per share and 50 shares of Stock B that sell for $58 per share? Portfolio Value| 90($84) + 50($58)| $10,460| Portfolio Weight| WeightA = 90($84)/$10,460| WeightA = . 7228| WeightB = 50($58)/$10,460| WeightB = . 2772| 11. 4 Portfolio Expected Returns.
You have $10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 16 percent and Stock Y with an expected return of 11 percent. If your goal is to create a portfolio with an expected return of 14. 25 percent, how much money will you invest in Stock X? In Stock Y? Investment X = 0. 6500($10,000) = $6,500| Investment in Y = (1 – 0. 6500) ($10,000) = $3,500| 11. 8Calculating Expected Returns. A portfolio is invested 20 percent in Stock G, 35 percent in Stock J, and 45 percent in Stock K. The expected returns on these stocks are 9 percent, 13 percent, and 19 percent, respectively.
What is the portfolio’s expected return? How do you interpret your answer? E(R) = . 20(. 09) + . 35(. 13) + . 45(. 19)| E(R) = 14. 90%| 11. 13Using CAPM. A stock as a beta of 0. 9, the expected return on the market is 13 percent, and the risk-free rate is 6 percent. What must the expected return on this stock be? E(Ri) = Rf + [E(RM) – Rf] ? bi| E(Ri) = . 06 + (. 13 – . 06)(0. 90)| E(Ri) = 12. 30%| Chapter #12 12. 1WACC. On the most basic level, if a firm’s WACC is 12 percent, what does this mean? What it means is that the minimum rate of return the firm must earn overall on its existing assets.
If the firm earns more than this, value is created. 12. 3 Project Risk. If you can borrow all the money you need for a project at 6 percent, doesn’t it follow that 6 percent is your cost of capital for the project? No because the cost of capital depends on the risk of the project, not the source of the money. 12. 7Cost of Debt Estimation. How do you determine the appropriate cost of debt for a company? Does it make a difference if the company’s debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?
The appropriate after tax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. That’s why, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm could still estimate its cost of debt by looking at the cost of debt for similar firms in similar risk classes, looking at the average debt cost for firms with the same credit rating that is assuming the firm’s private debt is rated, consulting analysts and investment bankers.
Even if the debt is publicly traded, an additional barrier is when the firm has more than one issue outstanding; these issues are rarely the same yield because no two issues are ever completely all the same. Questions and Problems (QP) 12. 1, 12. 5, 12. 7 & 12. 14 12. 1 Calculating Cost of Equity. The Boos Co. just issued a dividend of $2. 40 per share on its common stock. The company is expected to maintain a constant 6 percent growth rate in its dividends indefinitely. If the stock sells over $48 a share, what is the company’s cost of equity? RE = [$2. 40(1. 06)/$48] + . 06| RE = 11. 30%| 2. 5Calculating Cost of Preferred Stock. Sixth Fourth Bank has an issue of preferred stock with a $6 stated dividend that just sold for $94 per share. What is the bank’s cost of preferred stock? RP = $6/$94| RP = 6. 38%| 12. 7Calculating Cost of Debt. In-The-Dell Farm issued 30-year, 8 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? P0 = $1,080 = $40(PVIFAR%,46) + $1,000(PVIFR%,46)| R = 3. 639%| YTM = 2 ? 3. 639%| YTM = 7. 28%| b. What is the after tax cost of debt? RD = . 728(1 – . 35)| RD = 4. 73%| c. What is more relevant, the pretax or the after tax cost of debt? Why? The after-tax rate is more relevant because that is the actual cost to the company. 12. 14 WACC. Blue Bull, Inc. has a target debt-equity of . 22. Its WACC is 10. 50 percent, and the tax rate is 35 percent. a. If the company’s cost of equity is 14 percent, what is its pretax cost of debt? WACC = . 105 = (1/1. 55)(. 14) + (. 55/1. 55)(1 – . 35)RD| RD = 6. 36%| b. If the after tax cost of debt is 6. 5 percent, what is the cost of equity? WACC = . 105 = (1/1. 55)RE + (. 55/1. 55)(. 065)| RE = 12. 70%|
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