Expert Answers

Problem 1 
Consider the following information:

Stock A Stock B
Beta 0.8 1.4
Share price, $ 20 40
Standard deviation 25% 50%
Correlation between A and B 0.25
Treasury bills currently yield 2%, and the market risk premium is 6%.

(a) Compute the expected return and standard deviation of a portfolio of 100 shares of Stock A and 100 shares of Stock B. (8 points)

(b) Ajay has $10,000 to invest. He plans to invest $4,000 in Stock B. He will allocate the rest of his money to Treasury bills and Stock A. His goal is to construct a portfolio with a beta of 1.0. Compute the investment amounts (in dollars) in Treasury bills and Stock A required to achieve the goal. 

Problem 2
Consider a project that involves the purchase of a $100,000 machine. The machine will last for three years. It is expected to produce 20,000 units per year. The sales price for each unit will be $32, and variable costs will be $25 per unit. The project will also incur fixed labor costs of $45,000 per year. It will require no additional investment in net working capital and is expected to have a salvage value of $5,000 in three years. The machine will be depreciated using the MACRS schedule below (note that this schedule has 4 years of depreciation, but the machine will be sold after 3 years). The tax rate is 40%, and the discount rate is 10%. You may want do this problem in Excel, and then copy the numbers into your Word document.
Year MACRS %
1 33
2 44
3 15
4 8

(a) Construct a table of the relevant cash flows for this project, and compute the NPV and IRR of the project. (14 points)

(b) What is the minimum unit price (to the nearest cent) that would justify investment? You do not need to show all your work, but explain how you arrived at your answer. 

Problem 3
Angry Greek Pizza is a privately held (not publicly traded) firm with the following balance sheet:
($ in millions)
Fixed assets 100 Short-term debt 20
Long-term debt 30
Equity 50
Total 100 Total 100

In addition, you obtain the following information:

• The yield on the short-term debt is 100 basis points higher than the current yield of 3.5% on Treasury bonds.
• The long-term debt consists of 30-year bonds that pay an annual coupon of 6% on their $1,000 face value. Similar publicly traded bonds are currently yielding 6%.
• The company expects $2 million in net income for the coming year. Common stock of similar publicly traded firms currently has a price-earnings ratio of 30 and a beta of 1.2.
• The estimate of the market risk premium is 5%.
• The tax rate is 40%.
• The company plans to use $20 million in existing cash to repay the short-term debt immediately.
Compute the company’s weighted average cost of capital. Report your answer in decimal format to 3 decimal places, e.g., 7.1% would be reported as 0.071.