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10.33 The risk-free rate is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and an expected return of 16.7 percent. Assume the capital-asset-pricing model holds.
1. What is the expected market risk premium?
2. Magnolia Industries stock has a beta of 0.8. What is the expected return on the Magnolia stock?
3. Suppose you have invested $10,000 in a combination of Potpourri and Magnolia stock. The beta of the portfolio is 1.07. How much did you invest in each stock? What is the expected return of the portfolio?

39) The Tuft Company is generating cash flow of $333,000 per year. If they invest in a new press, they expect to increase their cash flow to $400,000 per year. The cash outflow for the new press is $250,000; to accept or reject the investment they have to consider the

A) press cost of $250,000 and total cash flow of $400,000 per year.
B) press cost of $250,000 and incremental cash flow of $67,000 per year.
C) current cash flow of $333,000 and the cost of $250,000

40) What is the nominal rate of interest given a real rate of interest of 5.0% and an inflation rate of 7.0%? (express your answer with one significant figure)
Ans. _______%

41) You have been asked to evaluate two pollution control devices. The wet scrub costs $100 to set up and $50 per year to operate. It must be completely replaced every 3 years, and it has no salvage value. The dry scrub device costs $200 to set up and $30 per year to operate. It lasts for 5 years and has no salvage value. Assuming pollution control equipment is replaced as it wears out, which method do you recommend if the cost of capital is 10%? Determine the equivalent annuity cost (EAC) and show your decision by marking your choice. All revenues are assumed to be the same.

43) ABC Inc. is considering the purchase of a $500,000 computer with an economic life of five years. The computer will be depreciated fully over five years using the straight line method. The market value of the computer is $100K in five years. The computer will replace five office employees whose combined annual salaries are $120K. The machine will also lower
the firms required net working capital (NWC) by $100K. This amount of NWC will need to be replaced once the machine is sold. Tc = 34%, discount rate is 12%. Determine the NPV to see if it is worth it?

Yr-0 Yr-1 Yr-2 Yr-3 Yr-4 Yr-5
Annual salary savings 120,000
Depreciation 100,000
Pre-tax income
Taxes 6,800
Operating C/F 113,200
ΔNWC -100,000
Investment -500,000 66,000
Total C/F 113,200

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10.33 The risk-free rate is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and an expected return of 16.7 percent. Assume the capital-asset-pricing model holds.
1. What is the expected market risk premium?
Using the CAPM equation
Expected return = Rf + (Rm-Rf) X beta
Where (Rm-Rf) is the market risk premium
16.7% = 7.6% + (Rm-Rf) X 1.7
(Rm-Rf) = (16.7%-7.6%)/1.7 = 5.35%

2. Magnolia Industries stock has a beta of 0.8. What is the expected return on the Magnolia stock?

Using the CAPM equation with market risk premium = 5.35%
Expected return = 7.6% + 5.35%X0.8
= 11.88%
3. Suppose you have invested $10,000 in a combination of Potpourri and Magnolia stock. The beta of the portfolio is 1.07. How much did you invest in each stock? What is the expected return of the portfolio?
The beta of a portfolio is the weighted average beta of individual stocks. Let A% be invested in Potpourri, then (100-A%) would be invested in Magnolia. The weighted average beta is
Portfolio beta = Proportion of Potpourri X beta of potpourri + Proportion of Magnolia X beta of magnolia
1.07 = A% X 1.7 + (100-A%) X 0.8
This gives A as 30%, so investment in Potpourri is 10,000X30%=$3,000 and the investment in Magnolia will be $7,000
Expected return = 0.3X16.7% + 0.7 X 11.88% = 13.33%

39) The Tuft Company is generating cash flow of $333,000 per year. If ...

Solution Summary

The solution has various finance questions relating to Risk premium, Magnolia beta, nominal rate of interest, EAC and NPV.

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