Fall, 2012 FNAN 401 HW #2 (Due Nov 7) 1.

. You have the following information for three securities: State 1 2 3 a) b) P .3 .2 .5 Stock AA .06 .14 .18 Stock BB .10 .22 .10 Stock CC .10 .10 .25

c)

Calculate the expected return and variance of return for all three securities Calculate the correlation of return between AA and BB, AA and CC, and BB and CC. Can diversification gains be obtained by combining these three stocks into a portfolio? Why or why not? If you could pick only two of these stocks to combine into a portfolio, which two would you pick? Why? Calculate the expected return and variance of return for a portfolio where 20% of your wealth is invested in AA, 30% in BB, and 50% in CC. You have the following information for the market portfolio (in addition, the risk-free rate is 9.15%): State P Market 1 .3 .087 2 .2 .153 3 .5 .177 Use the information above, and the information presented in question 1, to determine the beta for Stock CC? Plot the security market line in expected return, beta space. Label all axes and the points representing the market portfolio, the risk-free asset, and Stock CC. Be sure that you note the expected return and beta for these three points. What is the expected return for a portfolio that has a 40% investment in the risk-free asset, and a 60% investment in Stock CC? The McEnally Toy Corporation currently uses an injection molding machine that was purchased two years ago for $5,000. This machine is being depreciated on a straight line basis, and it has 6 years of remaining depreciable life. The estimated market value for the machine at the end of its useful (depreciable) life is $0. Richard McEnally is confident, however, that the machine could be sold today for $4,000. The firm is considering a replacement machine that will cost of $8,000, last 6 years, and have a market value of $800 at the end of its useful life. The replacement machine would permit an output expansion, so sales will be $1,000 higher (than with the old machine) each year for six years. In addition, due to the proposed machine's much greater efficiency, operating expenses will be $1,500 less (than with the old machine) in each year. The new machine would require that accounts receivable be increased from today's level of $40,000 to $45,000 at the end of year 1, $50,000 at the end of year 2, $52,000 at the end of years 3-5, and back down to $40,000 at the end of year 6. The firm's marginal federal-plus-state tax rate is 40 percent, and its cost of capital is 15 percent. Should it replace the old machine? Provide a numerical solution. 4. Fiber Glasses must choose between two different types of manufacturing facilities. They will continue to use whichever type they choose for the foreseeable future. Facility I costs $4.0 million and its economic (and depreciable) life is 4 years. The maintenance costs for facility I are $60,000 per year. Facility II costs $6 million and its economic (and depreciable) life is 7 years. The annual maintenance costs for facility II are $100,000 per year. Both facilities should be fully depreciated using the straight line method. The facilities have no value after their economic lives. The corporate tax rate is 34 percent. Revenues from the facilities are the same. The company is assumed to generate sufficient revenues to generate tax shields from depreciation. If the appropriate discount rate is 12 percent, which facility should Fiber Glasses choose? Why?

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a) b) c)

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