## Question

2. Two years ago, Gamma Inc. sold a $250 million bond issue to finance the purchase of new jet airliners. These bonds were issued in $1,000 denominations with an original maturity of 14 years and a coupon rate of 12% with interest paid semiannually. Determine the value today of one of these bonds to an investor who requires a 14 percent return on these securities. Explain why the bond has a value that is not equal to the par value.

3. Alpha Corporation has outstanding an issue of preferred stock with a par value of $100. It pays an annual dividend equal to 8 percent of par value. If the required return on Alpha’s preferred stock is 6 percent, and if Alpha pays its next dividend in one year, what is the market price of the preferred stock today? Explain why the price would change, if the required rate increased to 10 percent.

4. The real risk-free rate of return has been estimated to be 2 percent under current economic conditions. The 30-day risk-free rate (annualized) is 5 percent. Twenty-year U.S. government bonds currently yield 8 percent. The yield on 20 year bonds issued by the Forester Company is 14 percent. Investors require an 18 percent return on Forester's common stock. The common stock of Brown's Forensic Products has a required return of 20 percent. Compute and identify all meaningful risk premiums. What might account for the difference in the required returns for Brown versus Forester?

5. Barrett Industries invests a large sum of money in R & D; as a result, it retains and reinvests all of its earnings. In other words, Barrett does not pay any dividends and it has no plans to pay dividends in the near future. A major pension fund is interested in purchasing Barrett's stock. The pension fund manager has estimated Barrett's free cash flows for the next four years as follows: $3 million, $6 million, $10 million, and $15 million. After the fourth year, free cash flow is projected to grow at a constant 7% Barrett's WACC is 12%, its debt and preferred stock total $60 million, and it has 10 million shares of common stock outstanding. Required: a) Determine Barrett's enterprise value b) Estimate Barrett's price per share of common stock.

6. A portfolio manager is managing a $10 million portfolio. Currently the portfolio is invested in the following manner: Investment Dollar Amount Invested Beta Electric Utility $2 million 0.6 Cable Company $3 million 0.8 Real Estate Development $3 million 1.2 International Projects $2 million 1.4 Required: a) What is the portfolio’s beta? b) If the risk free-rate is 5% and the market risk premium is 5.5 %, what is the portfolio’s required rate of return? c) If the expected return on the portfolio for the upcoming year is 9.5% with a standard deviation of 4.5%, what is the probability that the portfolio will have a return greater than its required return? What is the probability the portfolio would have a negative return? The portfolio manager is considering a change in the strategic focus of the portfolio; it will reduce its reliance on the electric utility investment, reducing the investment to $1 million and at the same time increasing the investment in international projects to $3 million. Explain what will happen to the portfolio’s beta, as well as the required rate of return for the portfolio. What you do expect to happen to the portfolio’s expected rate of return and its standard deviation?

## Solution Preview

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4.Risk prwmium: Required rate of return – Risk free rate

Required Return: 20%

Rikf free return: 2%

Yeild of 20 years US government bond: 8%

Yeild of 20 years Forrestor bond: 14%

Forrestor Risk Premium:

Over Bond: 14 – 8% = 6%

Over Stock: 18% - 8% = 10%

Brown Forensic Products:

Risk Premium over market: 20- 8% = 12%

Factors that account for the difference in the required returns for Brown versus Forester re:

• The volatility of returns in short term

• The residual claim position of one stock to another

• The variability of dividends

• Stock specific risk premiums will vary the required return of different stocks....

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