## Market Portfolio Has an Expected Return

Market portfolio has an expected return of 11% and volatility of 20%. Risk-free rate is 3%. Security X and Y have betas of 1.4 and 0.9 respectively.

a) According to CAPM, what are the expected return of X and Y?

E(rm)-rf = 11% – 3% = 8%

3% +1.4*8% = 14.2%

3% +1.4 *8% = 10.2%

## NPV Calculation for LEZ Enterprises

LEZ Enterprises, Inc. has been considering the purchase of a new manufacturing facility for \$700,000. The facility is to be depreciated on a straight line basis over 14 years. It is expected to have no value after those 14 years. Cash flow from depreciation are considered to be risk-free and so they should be discounted at the risk-free rate. Operating revenues from the facility are expected to be \$160,000 during the first year. The revenues are expected to increase at the rate of 2.2% per year which is also expected to be the inflation rate. Production costs in the first year are \$25,000 and they are expected to remain constant each year. The project ends after 14 years. LEZ’s cost of capital is 15%. Its corporate tax rate 21%. The risk-free rate 3%. What is the NPV of this project?

This answer is available in the Excel file.

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## Question on HRE Mining Limited

Question on HRE Mining Limited for \$2 Only

HRE Mining Limited’s (HRE) is considering a major gold exploration project in South Sudan. Costs of financing have been declining recently causing the finance department to consider sourcing capital through debt and equity issues. The company’s bonds will mature in six years with a total face value of \$100 million, paying a half yearly coupon rate of 10% per annum. The yield on the bonds is 15% per annum. The market value for the company’s preference share is \$4.75 per unit while the ordinary share is currently worth \$1.85 per unit. The preference share pays a dividend of \$0.4 per share. The beta coefficient for the ordinary share is 1.4. No issue costs will be incurred by the company. The market risk premium is estimated to be 12% per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax rate and intends to issue 200,000 preference shares and 5,000,000 ordinary shares. HRE’s current balance sheet shows the following information for bonds and shares:

 \$ (Million) Number On Issue (million) Preference shares 3 1.5 Ordinary shares 15 15 Bonds 100 100,000

Using the information provided, calculate the market values for the financing sources for HRE. (7.5 marks)

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## Answer of The Real Risk Free Rate is 2.8%…

The real risk free rate is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next 5 years and 7% thereafter.

The maturity risk premium is determined from the formula : 0.1(t-1)%, where t is the security’s maturity. The liquidity premium (LP) on all Pellegrini Sourthern Inc.’s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating                   DRP

U.S. Treasury         —-

AAA                         0.60%

AA                           0.80%

A                             1.05%

BBB                        1.45%

1a. Pellegrini Southern Inc. issues 9-year, AA rated bonds. What is the yield on one of these bonds?Disregard cross-product terms; that is, if averaging is requried, use the arithmetic average.
a. 12.21%
b. 13.01%
c. 11.96%
​d. 5.45%

1b. Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
​a. Hiher inflation expectations increase the nominal interest rate demanded by investors.
​b. The yield on AAA-rated bond will be higher than the yield on a BB-rated bond.

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## Finance Question: NPV and CAPM Related

Finance Question: NPV and CAPM Related

Suppose that a project is to last 10 years, has an initial investment of \$20,000, and cash flows of \$2,000 per year and a terminal cash flow of \$9,000.

Further, suppose that the project has a beta of 1.2, the risk free rate is 5.5%, and the market premium is 7.0%. Calculate the NPV of this project and identify the decisions rule.

Price of Answer: Just US\$4 only

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## Exam III Review II Questions

Use the following information for Questions 1 and 2:

A stock has a required return on 11 percent. The risk-free is 7 percent, and the market risk premium is 4 percent.

1. What is the stock’s beta?
• 1.2
• 1.1
• 1.0
• 0.9

2. If the market risk premium increases to 6 percent, what will happen to the stock’s required rate of return?

• 6.00%
• 7.00%
• 11.00%
• 13.00%