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Question 1. (25 marks)
You are considering the following two stocks for your portfolio and have observed the following.
The risk free rate is 0.015 and you are considering investing 50% of your funds in Stock A and 50% in Stock B.
Calculate the following.
a) Expected Return of Stock A (.5 mark)
b) Expected Return of Stock B (.5 mark)
c) Variance of Stock A (.5 mark)
d) Variance of Stock B (.5 mark)
e) Standard Deviation of Stock A (.25 mark)
f) Standard Deviation of Stock B (.25 mark)
g) Coefficient of Variation of Stock A (.5 mark)
h) Coefficient of Variation of Stock B (.5 mark)
i) Covariance of Stocks A and B (1.5 marks)
j) Correlation Coefficient of Stocks A and B (.75 mark)
k) Portfolio Return (.75 mark)
l) Portfolio Standard Deviation and Variance (3 marks)
m) Weights of the Minimum Variance Portfolio (2 marks)
n) Proof that these weights lead to the Minimum Variance Portfolio (2.5 mark)
o) Weights of the Optimal Risky Portfolio with a risk-free asset (2 marks)
p) Proof that these weights lead to the Optimal Risky Portfolio (2.5 marks)
q) Discussion on what you would do with this portfolio (1.5 mark)
r) Beta for Stock A (1.5 marks)
s) Beta for Stock B (1.5 marks)
t) Capital Asset Pricing Model Estimate for Stock A (1 mark)
u) Capital Asset Pricing Model Estimate for Stock B (1 mark)
Question 2. (7.5 marks)
Extract from Balance Sheet of Bat Ltd.
Bonds (12%) $3,000,000
It is considering purchasing a new widget making machine which will cost $4,000,000.
Three options for financing the machine have been provided by the finance manager.
a) Borrow from the bank at a rate of 14%.
b) Sell preference shares with a 12% dividend
c) Sell ordinary shares for $16 each.
There are 800,000 ordinary shares already issued.
Tax rate is 40 per cent.
a) Given an EBIT of $1,500,000, calculate the EPS of the options. (2 marks)
b) Calculate the indifference points for the options. (2 marks)
c) Calculate the DFL for each option (using an EBIT of $1,500,000) (2 marks)
d) Which option would you recommend? (.75 mark)
e) What would EBIT need to increase by to make a change in the preferred option. (.75 mark)
Question 3. (7.5 marks)
You believe your firm could make better use of financial leverage and is considering alternative structures of 40% or 60%.
EBIT is expected to remain constant at $1,400,000.
Tax rate is 40%.
a) Calculate the times interest earned ratio for the 15%, 40% and 60% structures. (1.75 marks)
b) Evaluate the structures using both: (1 mark)
• Times interest earned
• Debt ratios
c) Construct an EPS-EBIT graph for the 15%, 40% and 60% structures. (2 marks)
d) Which option provides the better EPS. Why is this so? (.75 mark)
e) Calculate the firms market value of equity for the three structures using the zero-growth valuation model. (1.25 marks)
f) Which capital structure would you recommend? Why? (.75 mark)