Question 1 (35 marks)

Part I

IU Caf Group is downsizing. The company has just paid a $4.5 annual dividend and announces that the dividend will be lowered by 8 percent each year. Once the dividend amount becomes zero, the company will go out of business.

REQUIRED

1. Given the companys situation, the risk-free rate is 4 percent per annum, the market risk premium is 10 percent, and the stocks CAPM beta is 1.2. What are the required rate of return based on CAPM and thus, the firms stock price before the change in market risk premium on a per share basis?

2. Because of the epidemic, the market risk premium rises to 15 percent. The risk-free rate and the stocks CAPM beta remain the same as 4 percent per annum and 1.2 respectively. What is the firms stock price after the change in market risk premium on a per share basis?

3. Based on answers in above parts (a) and (b), calculate the percentage change in the firms stock prices. Briefly describe your observations about the stock price reactions to the change in market risk premium [within 60 words].

Part II

You are the financial manager of C&C Ltd and make use of weighted average cost of capital (WACC) to evaluate a potential project for further expansion.

C&C Ltd. will pay a $0.8 per share dividend next year. The company pledges to increase its dividend by 4% per year, indefinitely. The current market of common stock is $25. The current market prices of preferred stocks and zero-coupon bonds are $125 and $525 respectively. The company is subject to the corporation tax rate of 25 percent. The following information is extracted from the companys balance sheet this year.

Long term liabilities:	$000
Zero-coupon bonds payable due in 15 years, $1,000 par value, 3,600 bonds issued, and outstanding	3,600
Shareholders equity:	$000
8% preferred stocks, $100 par value, 4,000 shares authorized, 3,000 shares issued and outstanding	300
Common stocks, $5 par value, 300,000 shares authorized, 200,000 shares issued and outstanding	1,000
Retained earnings	300

REQUIRED

a) Calculate cost of common stock, preferred stock and after-tax cost of bond.

b) Calculate the companys weighted average cost of capital (WACC).

Question 2 (15 marks) Part I Consider the following information

State of Economy	Probability of State of Economy	Rate of Return if State Occurs Stock
		Stock J	Stock K	Stock L
Boom	0.3	0.22	0.5	0.24
Good	0.45	0.14	0.4	0.18
Poor	0.25	0.05	-0.15	-0.08
Bust	0.05	-0.13	-0.35	-0.12

REQUIRED a) If your portfolio is invested 30 percent each in stock K and L and 40 percent in stock J. What is the expected return of portfolio? b) What is the variance and standard deviation of this portfolio?

Part II Jack Hui is evaluating the performance of IU stock and stock market index considering the expected return, beta and standard deviation. The risk-free rate is 3.5%.

Stock	Expected Return	Beta	Standard Deviation
IU	13.5%	1.3	7%
Market	10.5%	1.0	5%

REQUIRED Based on Capital Asset Pricing Model (CAPM), will you recommend to buy or sell the IU stock? Illustrate with calculations on the differences between the expected return and the CAPM required return of IU stock to conclude your answer within 20 words.