The following two stocks are available for purchase. Utilize this information to answer questions 1-10.

Stock A Stock B
State p(i) E(Ra) E(Rb)
Recession 30% -30% -20%
Normal 40% 10% 10%
Expansion 30% 50% 30%
Beta 1.4 1.25
Rf 3%
RM 8%

1) What is the expected return on Stock A across all market situations? What is the expected return on Stock B across all market situations?

2) What is the standard deviation of Stock A’s return? What is the standard deviation of Stock B’s return?

3) With a mix of 75% Stock A and 25% Stock B what is the portfolio return? With a mix of 75% Stock A and 25% Stock B what is the portfolio standard deviation?

4) Which of the two stocks has higher total risk? Which of the two stocks has higher systematic risk?

5) Which of the two stocks has a higher Reward-to-Risk Ratio? Are the two stocks under or over-valued based on the Capital asset Pricing Model?

6) What return would you expect on each stock based on the Capital Asset Pricing Model?

7) On the most basic level, if a firm’s WACC is 12%, what does this mean?

8) Why do we use an after-tax figure for the cost of debt but not for the cost of equity?

9) If you can borrow all the money you need for a project at 6%, doesn’t it follow that 6% is your cost of capital
for this project?

10) How do you determine the approximate cost of debt for a company? Does it make a difference if the company’s debt is privately placed as opposed to publicly traded? How would you estimate the cost of debt for firm whose only debt issues are privately held by institutional investors?

Answer rating: 100% (QA)

1 Expected return across all market situations for A is 10 Expected return across all market situati... View the full answer