1. Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks:

Expected Return Volatility Beta

Green Leaf 12% 20% 1.5

Nat Sam 10% 40% 1.8

HanBel 9% 30% 0.75

Rebecca Automobile 6% 35% 1.2

a. At current market prices, which stocks represent buying opportunities?

b. On which stocks should you put a sell order in?

2. Consider the price paths of the following two stocks over six time periods

1 2 3 4 5 6

Stock 1 10 12 14 12 13 16

Stock 2 15 11 8 16 15 18

Neither stock pays dividends. Assume you are an investor with the disposition effect and you bought at time 1 and right now it is time 3. Assume throughout this question that you do no trading (other than what is specified) in these stocks.

a. Which stock(s) would you be inclined to sell? Which would you be inclined to hold on to?

b. How would your answer change if right now is time 6?

c. What if you bought at time 3 instead of 1 and today is time 6?

d. What if you bought at time 3 instead of 1 and today is time 5?

3. Assume the economy consisted of three types of people. 50% are fad followers, 45% are passive investors (they have read this book and so hold the market portfolio), and 5% are informed traders. The portfolio consisting of all the informed traders has a beta of 1.5 and an expected return of 15%. The market expected return is 11%. The risk-free rate is 5%.

a. What alpha do the informed traders make?

b. What is the alpha of the passive investors?

c. What is the expected return of the fad followers?

d. What alpha do the fad followers make?

4. Each of the six firms in the table below is expected to pay the listed dividend payment every year in perpetuity.

Firm Dividend ($ million) Cost of Capital (%/Year)

S1 10 8

S2 10 12

S3 10 14

B1 100 8

B2 100 12

B3 100 14

a. Using the cost of capital in the table, calculate the market value of each firm.

b. Rank the three S firms by their market values and look at how their cost of capital is ordered.

What would be the expected return for a self-financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value? (The expected return of a self-financing portfolio is the weighted average return of the constituent securities.) Repeat using the B firms.

c. Rank all six firms by their market values. How does this ranking order the cost of capital?

What would be the expected return for a self-financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value?

d. Repeat part c but rank the firms by the dividend yield instead of the market value. What can you conclude about the dividend yield ranking compared to the market value ranking?

5. Consider the following stocks, all of which will pay a liquidating dividend in a year and nothing in the interim:

Market Capitalization ($ million) Expected Liquidating Dividend ($ million) Beta

Stock A 800 1000 0.77

Stock B 750 1000 1.46

Stock C 950 1000 1.25

Stock D 900 1000 1.07

a. Calculate the expected return of each stock.

b. What is the sign of correlation between the expected return and market capitalization of the stocks?

6. You are currently considering an investment in a project in the energy sector. The investment has the same riskiness as Exxon Mobil stock (ticker: XOM). Using the data in Table 13.1 and the table above, calculate the cost of capital using the FFC factor specification if the current risk-free rate is 3% per year.

Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

In mid-2012, AOL Inc. had $100 million in debt, total equity capitalization of $3.1 billion, and an equity beta of 0.90 (as reported on Yahoo! Finance). Included in AOL's assets was $1.5 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 3% and the market risk premium is 4%.

a. What is AOL's enterprise value?

b. What is the beta of AOL's business assets?

c. What is AOL's WACC?