$6,000 $7,715 $10,500 $9,000 Question 2 Consider the following linear regression model: The ei in the regression measures the historical performance of the security relative to the expected return predicted by the SML. measures the diversifiable risk in returns. measures the deviation from the best fitting line and is zero on average. measures the sensitivity of the security to market risk. Question 3 Consider the following information regarding corporate bonds: Rating AAA AA A BBB BB B CCC Average Default Rate 0.0% 0.0% 0.2% 0.4% 2.1% 5.2% 9.9% Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 43.0% Average Beta 0.05 0.05 0.05 1.0 0.17 0.26 0.31 Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%, and a BBB rating. The bondholders expected loss rate in the event of default is 70%. Assuming a normal economy the expected return on Wyatt Oil’s debt is closest to: 3.0% 3.5% 6.7% 4.9% Question 4 Consider the following information regarding corporate bonds: Rating AAA AA A BBB BB B CCC Average Default Rate 0.0% 0.0% 0,2% 0,4% 2.1% 5.2% 9.9% Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 43.0% Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31 Company Market Capitalisation ($mm) Total Enterprise Value ($mm) Equity Beta Debt Rating Taggart Transcontinental $4,500 8,000 1.1 BBB Rearden Metal $3,800 7,200 1.3 AAA Wyatt Oil $2,400 3,800 0.9 A Nielson Motors $1,500 4,400 1.75 BB Your estimate of the asset beta for Taggart Transcontinental is closest to: 0.59 0.71 0.66 0.42 Question 5 RON Ltd has the following capital structure components: Five million shares issued with a current market price of 11. Equity holders require a 10% return. $10 million face value of Corporate bonds outstanding. These bonds pay an annual coupon of 6% and currently trade at a yield to maturity of 6%. If the firm faces a corporate tax rate of 30%, compute RON Ltd’s Weighted Average Cost of Capital (WACC). Enter your answer in decimal form to FOUR decimal places. For example 10.34%, would be entered as 0.1034 Question 6 If a project has a higher proportion of fixed to variable costs, holding the risk of its revenues constant its beta will be lower, hence its cost of capital will be lower. its financial leverage will be higher. its beta will be higher, hence its cost of capital will be higher. its beta will be unaffected, since beta does not measure the sensitivity of the project’s cash flows to market risk. Question 7 Which of the following statements is FALSE? We should be suspicious of beta estimates that are extreme relative to industry norms. For stocks, common practice is to use at least two years of weekly return data or five years of monthly return data when estimating beta. When using historical data, there is always the possibility of estimation error. Evidence suggests that betas tend to revert toward zero over time. Question 8 John Galt is a mutual fund manager at Atlas Asset Management. He can generate an alpha of 2% a year up to $500 million of invested capital. After that amount his skills are spread too thin, so he cannot add value and his alpha is zero for all investments over $500 million. Atlas Asset Management charges a fee of 0.80% on the total amount of money under management. Assume that there are always investors looking for positive alpha investments and no investor would invest in a fund with a negative alpha. Assume that the fund is in equilibrium, meaning that no investor either takes out money or wishes to invest new money into the fund. The amount of money that Galt’s fund will have under management is closest to: $500 million $1,250 million $600 million $1,000 million Question 9 Which of the following statements is FALSE? The largest alphas occur in the smallest size deciles. When considering portfolios formed based on size, although the portfolios with the higher betas yield higher returns, most size portfolios plot above the security market line. When considering portfolios formed based on the market-to-book ratio, most of the portfolios plot below the security market line. The size effect is the observation that small stocks have positive alphas. Question 10 Assume that the economy has three types of people. 15% are fad followers, 75% are passive investors, and 10% are informed traders. The portfolio consisting of all informed traders has a beta of 1.3 and an alpha of 1.91%. The market has an expected return of 12% and the risk-free rate is 4 %.What is the alpha for the fad followers? Enter your answer as a percentage to two decimal places (i.e. 0.12% rather than 0.0012; the percent sign is not necessary).