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Managerial Finance Week 5 Class Exercises. OVU- ADVANCE David Hamm, MBA, CPA January 2006 +. Chapter 13 case—Slide 1. You are considering a portfolio of three stocks Raeder (RMP) Boom=16% Avg=10% Bust=5% Yamamoto (YEC) Boom=24% Avg=13% Bust=-2% King (KCT) Boom=7% Avg 8.5% Bust=16%

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## Managerial Finance Week 5 Class Exercises

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**Managerial FinanceWeek 5 Class Exercises**OVU-ADVANCE David Hamm, MBA, CPA January 2006 +**Chapter 13 case—Slide 1**• You are considering a portfolio of three stocks • Raeder (RMP) Boom=16% Avg=10% Bust=5% • Yamamoto (YEC) Boom=24% Avg=13% Bust=-2% • King (KCT) Boom=7% Avg 8.5% Bust=16% • Probability of boom market= 25% • Probability of average returns=50% • Probability of bust market=25%**Expected Returns (Wt. Average)**• Raeder (RMP): • Boom: 25% x 16% return = .04 • Avg: 50% x 10% return = .05 • Bust: 25% x 5% return = .0125 • Totals: .1025 or 10.25% • Yamamoto (YEC): • Boom: 25% x 24% return = .06 • Avg: 50% x 13% return = .065 • Bust: 25% x -2% return = -.005 • Totals: .120 or 12%**Expected Return (Wt. Avg. )-2**• King (KCT) • Boom: 25% x 7% return = .0175 • Avg: 50% x 8.5% return= .0425 • Bust: 25% x 16% return = .04 • Totals .1000 or 10%**Uncle Fred’s Bequest**• Dear departed Uncle Fred leaves you $150K which you invest as follows: • RMP $45K • YEC $60K • KCT $45K • Calculate the “weighting” of the three stocks in your new portfolio • Solution: RMP & KCT: 45/150 =30% • Solution: YEC: 60/150 = 40% Note: total % must equal 100%**Portfolio Expected Return**• RMP: 30% x 10.25% =3.075% • YEC: 40% x 12.0 % = 4.800% • KCT: 30% x 10.0% = 3.000% • Total E(R) portfolio = 10.875% • Risk premium, if risk free rate is 4%: • 10.875% - 4% = 6.875%**Portfolio Beta**• If β (RMP) = 1.0; Β (YEC) = 1.5; and β (KCT) =.75 • Portfolio beta: • RMP 30% x 1.0 = .3 • YEC 40% x 1.5 = .6 • KCT 30% x .75 = .225 • β (portfolio) = 1.125**CAPM for Raeder**• CAPM = Rf + (Rm –Rf) x β asset • E(R) = 4% +(10% - 4%) x 1.0 • E(R) = 4 % + (6% x 1.0) • E(R) RMP = 10% • Note: at a beta of 1.0, Raeder would follow the market expected return of 10%**CAPM for Yamamoto**• CAPM = Rf + (Rm –Rf) x β asset • E(R) = 4% + (10%-4%) x 1.5 • E(R) = 4 % + (6% x 1.5) • E(R) = 4% + 9% • E(R) YEC= 13% • Note: at a beta of 1.5, Yamamoto would exceed the market expected return of 10%**CAPM for King**• CAPM = Rf + (Rm –Rf) x β asset • E(R) = 4% + (10%-4%) x .75 • E(R) = 4 % + (6% x .75) • E(R) = 4% + 4.5% • E(R) KCT= 8.5% • Note: at a beta of .75, King would be below the market expected return of 10%**Introducing MIC**• Military Industrial Complex, Inc (MIC): • 2.5 MM shares outstanding @ $40 mkt price • Debt: $30MM trading at 95% of face • Beta= 1.30 Tax Rate = 40% • Market rates: Rm=10% Rf=4% risk premium=6% (Rm-Rf)**CAPM for MIC**• RE = Rf + (Rm –Rf) x β asset • RE =4% + (6% x 1.3) • RE = 4% + 7.8% • RE = 11.8% • We need this figure for the return on equity figure for the WACC calculation**Equity & Debt in MIC portfolio**• Equity valuation (at market): • 2.5 MM shares x $40 = $100 MM • Debt valuation (at market) • $30 MM x 95% = $28.5 MM • Weighting of equity & debt %: • Equity % = 100.0 MM or .778 (77.8%) • Debt % = 28.5 MM or .222 (22.2%) • Total % = 128.5 MM 100.0%**WACC for MIC**• WACC = [(E/V) x RE] + [D/V) x RD x 1-TC] • WACC= (.778 x .118)+ (.222 x .10 x .6) • WACC= .0918 + .0133 • WACC= .1051 or 10.51% • This is MIC’s required earnings rate (cost of capital) given its beta and the fact that 40% of its debt cost can be deducted for income tax purposes**MIC and Leverage possibilities**• MIC has started a new subsidiary (MIC-2) to make a $50MM investment. • Assume “cost plus” arrangement with DoD will guarantee a 20% EBIT ($10MM yr) • MIC has already capitalized 50% of investment with 1 MM shares @ $25 each • It could raise another 1 MM shares or borrow $25MM at 10% • What should MIC-2 do?**Zero vs 50% leverage (at 20% EBIT)**ROE and EPS based on $25 MM equity at 50% leverage (1 MM shares) vs $50 MM equity or 2 MM shares at 100% equity**Zero vs 50% leverage (at 10% EBIT)**All equity 50% At 10% return the bottom line is “indifferent” and therefore probably not worth the risk of financial distress to borrow 50%**Zero vs 50% leverage (at 8% EBIT)**All equity 50% At a rate of return below borrowing costs, the firm would incur a “loss” to utilize debt leverage.

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