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Question

1. (5) A broad diversified bundle of stocks is expected to return RMbar = 9%, with a variance of

sM2 = 36%2. The risk-free rate of return RF = 1%.

a. Gabrielle is somewhat cautious, so she invests 30% of her \$10,000 portfolio in stocks, and 70% in risk-free Treasury bills. What is the expected return, standard deviation and coefficient of variation for her portfolio?

b. Gabrielle's friend Thomas is more adventuresome. He also has \$10,000 in funds, but he invests twice that much in the stock market by using his stockbroker's margin account. (That is, he borrows another \$10,000 to buy stocks). What is the expected return, standard deviation and coefficient of variation for his portfolio? How much interest (in \$) must he pay back to the broker per year?

c. Their friend Sarah wants to earn a return of 12%. What should her portfolio weights be for stocks and for Treasury bills? What is the standard deviation and CV for this portfolio?

d. Sketch a graph showing how these friends' portfolios are positioned along the capital market line.

2. (11) Suppose stock A has a beta value of bA= .6. Stock B has a beta of bB= 1.0. Stock C has a beta of bC= 2.5.

a. Find the required rate of return for each stock, if the risk-free rate of return is 2% and the market risk premium is 6%.

b. Suppose each stock recently paid a dividend of \$1.00. Stock A's dividend is expected to grow forever at 2%; stock B's dividend is expected to grow forever at 4%, and Stock C's dividend is expected to grow for 2 years at 25%, then at 4% thereafter. Using your answer from part a, find the current market price of each stock.

c. Consider the following 4 changes to the security market line in part a:

1. The risk free rate of return increases to 3% (market risk premium still 6%)

2. The risk free rate of return declines to 0% (market risk premium still 6%)

3. The market risk premium rises to 8% (risk free rate still 2%)

4. The market risk premium declines to 4% (risk free rate still 2%)

For each scenario above, sketch a graph that shows the original and the new SML. Now, find out the new price of A, B and C in each case.

3. (20) Look up the following 9 stocks (recommended site: http://finance.yahoo.com/ .)

Exxon Mobil XOM a. For each stock, find:

Newmont Mining NEM *sector and industry

Macy’s M *price (will vary by day you look it up)

General Electric GE * trailing EPS (past 12 months) and P/E ratio

Apple AAPL *trailing dividend per share (past 12 months)

Merck MRK *beta estimate

Ford Motor F *market cap

Wells Fargo WFC *long term debt (from financials, balance sheet)

*calculate debt ratio = long term debt/market cap

Note: firms with negative EPS will not have a P/E ratio, and some firms pay 0 dividends

3. cont'd

b. Looking at your results, which 3 stocks had the lowest P/E ratios? Which 3 had the highest P/E ratios? (for the moment, ignore firms with negative earnings)

What are some possible reasons why P/E ratios differ so much between firms? Do you see any relationship or pattern between the level of the P/E ratio and the type of industry?

c. Looking again at your results, which 3 stocks had the lowest beta estimates? Which 3 had the highest beta estimates? Does there appear to be any relationship between beta, the type of industry, and/or the debt ratio?