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3. Suppose the portfolio of a large institutional investor Animal has a beta of 1.25, and the standard deviation of the rate of return on its portfolio is 15 percent and its expected rate of return is 15 percent. The portfolio of another institutional investor Beast has a beta of 0.75. The market portfolio may be expressed as a portfolio comprising the portfolios of Animal and Beast. Suppose there is a firm called Cunning corporation, whose stocks beta is 2 and it can borrow at the risk free rate, which is 2.5 percent. Cunnings equity value is £1.5 million and its debt is £1 million. The present value of Cunnings tax shield is £0.3 million. Assuming that both CAPM and the Modigliani-Miller theorem with corporate taxes hold, answer the following questions. a) What is the expected return on the market portfolio? [5 marks] b) What is the standard deviation of the rate of return on Beasts portfolio? [5 marks] c) What is the weight attached to Beast if we express the market portfolio as a portfolio [5 marks] [5 marks] Total 20 marks] comprising the portfolios of Animal and Beast? d) What is the after-tax WACC of Cunning?
2. A firm Kappa Industries is a very young business, which is growing rapidly and to which intangible assets are very important. In contrast, another firm Gorgeous Food, whose business is profitable and stable, but has limited growth opportunities and most of its assets are tangible. With this setup, answer the following questions. a) Assuming that the predictions of the pecking order theory hold, which firm should have [20 marks] b) Assuming that the predictions of the trade-off theory hold, which firm should have a [20 marks] a higher payout ratio? Explain concisely why. higher debt-equity ratio? Explain concisely why.
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Answer #1

Answer 3)

a)

b)

Beta should be proportional to standard deviation. Hence, σ B / σΑ = BB / BA; Hence, ƠB = ƠA x BB / BA = 1596 x 0.75 / 1.25-9.0096

c)

Lets say, the market portfolio can be expressed as a portfolio comprising of proportion p of Animal and proportion (1-p) of Beast. Hence, resultant beta of the portfolio-p x BA + (1-p) x BB = p x 1.25 + (1-p) x 0.75 0.75 + 0.50 x p = beta hence, p 1- 0.75)/0.5-0.5 So the weight attached to Beast 1-p-1-0.5-0.5 5096.

d)

Answer 2)

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