as372s06t2 - term corporate bond fund The market statistics...

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Actsc 372 Test #2 - SPRING 2006 Name: Marks: /30 I.D.#: July 10, 2006, 1:30-3:00pm (90 minutes) 4 Questions, 5 Pages Aids: Calculator 1. [6 marks] RIM is interested in investing in a project that will cost $1,000,000 and will provide a pretax annual cash flows of $400,000 for 5 years. The project risk is similar to the overall risk of the firm. Given further that RIM’s cost of equity capital is 30%, before-tax cost of debt is 10%, and the firm’s debt-to-equity is 3.0. Should RIM invest in this project if the firm’s tax rate is 35%?
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2 2. [8 marks] The risk-free rate is 5%. You are considering two stocks: CIBC and GM. CIBC stock has a beta of 1.6 with an expected return of 20% while GM has a beta of 0.9. Assume CAPM holds. (a) What is the expected market risk premium? (b) Suppose you have invested $20,000 in a portfolio consists of CIBC and GM stocks that has portfolio beta 1.2. How much did you invest in each stock? What is the expected return of the portfolio?
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3 3. [12 marks] You are considering the following mutual funds: a stock fund and a long-
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Unformatted text preview: term corporate bond fund. The market statistics on these two funds are as follows: Expected Return Standard Deviation Stock fund 0.25 0.40 Bond fund 0.10 0.20 Correlation between the fund returns is 0.3 (a) Suppose you are an investor who is extremely risk averse and would like to avoid as much risk as possible. Derive explicitly your investment portfolio based on the information given above, assuming an initial investment amount of $1,000. 4 (Question 3 Cont’d) (b) In addition to the above market information, suppose now the economy exists a T-bill which is a risk-free asset with return 5%. Determine, by using an appropriate optimization, the optimum reward-to-variability ratio of the best feasible Capital Allocation Line? 5 4. [4 marks] The efficient market hypothesis implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore we can simply pick mutual funds at random. Is this statement true or false? Explain....
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