Question 3 A 7.5 points

Consider the following information on Stocks I and II:

		Rate of Return if State Occurs
State of Economy	Probability of State of Economy	Stock I	Stock II
Recession	.35	.05	-.16
Normal	.40	.21	.14
Irrational exuberance	.25	.15	.21

The market risk premium is 10 percent, and the risk-free rate is 5 percent.

a-1. What is the beta of each stock?

a-2. Which stock has the most systematic risk?

b-1. What is the standard deviation of each stock?

b-2. Which one has the most unsystematic risk?

c. Which stock is riskier? why? Please explain clearly.

Question 3 B 2.5 points

Suppose you observe the following situation:

Security	Beta	Expected Return
Funny Co.	1.70	13.6
Super-Funny Co.	.85	10.8

Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate?

Question 4 10 points

Zarb Corp. has a debt-equity ratio of .65. The company is considering a new plant that will cost $137 million to build. When the company issues new equity, it incurs a flotation cost of 8 percent. The flotation cost on new debt is 3.5 percent.

a. What is the initial cost of the plant if the company raises all equity externally?

b. What is the initial cost of the plant if the company typically uses 60 percent retained earnings?

c. What is the initial cost of the plant if the company typically uses 100 percent retained earnings?

Thank you