Question 1

Define the following terms:

1. Risk
2. Probability distribution
3. Standard deviation
4. Required rate of return
5. Coefficient of variation
6. Efficient portfolio
7. Efficient frontier
8. Capital market line
9. Beta coefficient
10. CAPM
11. Correlation coefficient
12. Portfolio
13. Characteristic line
14. Security market line
15. Covariance
16. Systematic risk
17. Unsystematic risk

Question 2

Under what circumstances can the beta concept be used to estimate the rate of return required by investors in a stock? What problems are encountered when using the CAPM?

Question 3

BASICYou have estimated the following probability distributions of expected future returns for Stocks X and Y:

1. What is the expected rate of return for Stock X? For Stock Y?
2. What is the standard deviation of expected returns for Stock X? For Stock Y?
3. Which stock would you consider to be riskier? Why?

Question 4

INTERMEDIATEUsingEquation 8.17, suppose you have computed the required rate of return for the stock of Bulldog Trucking to be 16.6 percent. Given the current stock price, the current dividend rate, and analysts' projections for future dividend growth, you expect to earn a rate of return of 18 percent.

1. Would you recommend buying or selling this stock? Why?
2. If your expected rate of return from the stock of Bulldog is 15 percent, what would you expect to happen to Bulldog's stock price?

Equation 8.17 (CAPM)

Question 5

CHALLENGEBostonmarket.comstock has an estimated beta of 1.5. The stock pays no dividend and is not expected to pay one for the foreseeable future. The current price of the stock is $50. You expect this price to rise to $60 by the end of the coming year. You believe that the distribution of possible year-end prices is approximately normal with a standard deviation of $2.50. The risk-free rate of return is currently 4 percent and the market risk premium is 8.8 percent. What is the probability that bostonmarket.com's stock is currently overvalued?

Question 6

Why is corporate long-term debt riskier than government long-term debt?

Question 7

What factors determine the required rate of return for any security?

Question 8

BASICCalculate the after-tax cost of a $25 million debt issue that Pullman Manufacturing Corporation (40% marginal tax rate) is planning to place privately with a large insurance company. This long-term issue will yield 9.375 percent to the insurance company.

Question 9

CHALLENGEWentworth Industries is 100 percent equity financed. Its current beta is 0.9. The expected market rate of return is 14 percent and the risk-free rate is 8 percent.

1. Calculate Wentworth's cost of equity.
2. If Wentworth changes its capital structure to 30 percent debt, it estimates that its beta will increase to 1.1. The after-tax cost of debt will be 7 percent. Should Wentworth make the capital structure change?

Question 10

INTERMEDIATEThe Folske Fan Corporation has four divisions:

The (leveraged) beta for Folske has been estimated to be 1.25. The company believes that the (leveraged) beta for consumer products is 1.2; for consulting, 1.3; and for financial services, 1.5. The appropriate capital structure for the industrial products division is 70 percent equity and 30 percent debt (and all projects in that division are currently financed in those proportions). The firm's consolidated capital structure consists of 60 percent equity and 40 percent debt. The risk-free rate is 9 percent, and the market risk premium is 8.6 percent. Folske's marginal tax rate is 40 percent. What is the minimum rate of return that Folske should demand on the equity-financed portion of investments in its industrial products division, assuming these investments continue to be financed with 70 percent equity and 30 percent debt?