1. You are considering investing in the two securities in the table below: (30 points)

State of the Economy / Probability / Return on
Alpha Inc. / Return on
Beta Inc.
Bear / .6 / 4% / 3%
Bull / .4 / 16% / 3%
  1. Calculate the expected returns and the standard deviations of the two securities.

E(Ra)=.6*4+.4*16=8.8%; E(Rb)=.6*3+.4*3=3%

Variance(Alpha) = .6(4-8.8)2+.4(16-8.8)2=13.824+20.736=34.56

Standard Dev.(Alpha)=5.87%; Variance(Beta)=0

  1. You have $10,000 to invest. Calculate the expected return and standard deviation of your portfolio if you invest $3,000 in Alpha and $7,000 in Beta.

E(Rp)=.3(8.8)+.7(3)=4.74%; Standard Dev. = .3(5.87)=1.761%

  1. You would like a portfolio with an expected return of 10%. Explain how you could invest in the two securities above to form this portfolio.

10=8.8x+(1-x)*3; x=1.2069; Invest 120.69% in Alpha and –20.69% in Beta. (You would sell beta and invest more than 100% in alpha)

  1. The risk-free rate is 7%, and the expected return of the market is 15%. Cushman Company has a beta of 0.8. What is the expected return of Cushman Company? (5 points) 7+.8(15-7)=13.4%
  1. You are considering investing in the two securities Macro and Micro. (20 points)

Macro / Micro
Expected Return / 12% / 30%
Standard Deviation / 10% / 22%
Correlation of the two securities = -0.3

Calculate the expected return and standard deviations of a portfolio that is composed of 40% Macro and 60% Micro. .4(12)+.6(30)=22.8%;

Variance=.42(.10)2+.62(.22)2+2*.4*.6(.1)(.22)(-.3)= .015824; Standard Deviation=12.58%

  1. Many investors claim to observe patterns in stock market prices. Is technical analysis consistent with the Efficient Market Hypothesis? If not, what form of market efficiency is violated? (5 points) Weak form.
  1. Calculate the five-year holding period return for the Vanguard Total Bond Fund: (5 points) (1-.086)(1-(-.008))(1.114)(1-.084)(1-.083)=1.4089-1=40.89%

Year / Return
1998 / 8.6%
1999 / -0.8%
2000 / 11.4%
2001 / 8.4%
2002 / 8.3%
  1. HQ Company has invested in a facility to produce financial calculators. The price of the machine is $600,000 and its economic life is five years. The machine is fully depreciated by the straight-line method and will produce 20,000 calculators in the first year. The variable cost per unit is $20, while fixed costs are $1,000,000. The corporate tax rate for the company is 30 percent. The company’s cost of capital is 15%. (20 points)
  2. What price would you have to charge per calculator to break-even in an accounting sense?

20000=(1000000+120000)/(p-20); P=76

  1. What price would you have to charge per calculator to break-even in a financial sense?

NPV=-600000+OCF*PVIFA(5,15%); OCF = 178989.33

178989.33=(20000p-20*20000-1000000)(.7)+.3(120000); P=80.21

  1. First Security, Inc. is considering a new project that costs $25 million. The project will generate after-tax (year-end) cash flows of $6 million for 7 years. The firm has a debt to equity ratio of 0.50. The cost of equity is 16% and the cost of debt is 9%. The corporate tax rate is 35%. The project has the same risk as that of the overall firm. Should First Security undertake the project? (15 points)

WACC=(2/3)(16)+(1/3)(9)(1-.35)=12.62%; NPV=1.8525 million; Yes.