# The Efficiency of the Market Portfolio

Question 1

The Debt Cost of Capital

14. In mid-2012, Ralston Purina had AA-rated, 10-year bonds outstanding with a yield to maturity

of 2.05%.

a. What is the highest expected return these bonds could have?

b. At the time, similar maturity Treasuries have a yield of 1.5%. Could these bonds actually

have an expected return equal to your answer in part (a)?

c. If you believe Ralston Purina's bonds have 0.5% chance of default per year, and that expected

loss rate in the event of default is 60%, what is your estimate of the expected return for these

bonds?

Question 2

The Behavior of Individual Investors

9. Your brother Joe is a surgeon who suffers badly from the overconfidence bias. He loves to trade

stocks and believes his predictions with 100% confidence. In fact, he is uninformed like most investors.

Rumors are that Vital Signs (a startup that makes warning labels in the medical industry) will

receive a takeover offer at $20 per share. Absent the takeover offer, the stock will trade at $15 per

share. The uncertainty will be resolved in the next few hours. Your brother believes that the takeover

will occur with certainty and has instructed his broker to buy the stock at any price less than $20. In

fact, the true probability of a takeover is 50%, but a few people are informed and know whether the

takeover will actually occur. They also have submitted orders. Nobody else is trading in the stock.

a. Describe what will happen to the market price once these orders are submitted if in fact the takeover

will occur in a few hours. What will your brother's profits be: positive, negative, or zero?

b. What range of possible prices could result once these orders are submitted if the takeover

does not occur? What will your brother's profits be: positive, negative, or zero?

c. What are your brother's expected profits?

Question 3

The Efficiency of the Market Portfolio

14. Davita Spencer is a manager at Half Dome Asset Management. She can generate an alpha of

2% a year up to $100 million. After that her skills are spread too thin, so cannot add value and

her alpha is zero. Half Dome charges a fee of 1% per year on the total amount of money under

management (at the beginning of each year). Assume that there are always investors looking for

positive alpha and no investor would invest in a fund with a negative alpha. In equilibrium, that

is, when no investor either takes out money or wishes to invest new money,

a. What alpha do investors in Davita's fund expect to receive?

b. How much money will Davita have under management?

c. How much money will Half Dome generate in fee income?

PLEASE ADVISE HOW MANY CREDIT THIS REQUIRES

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#### Solution Preview

See the attached file. Thanks

Question 1

The Debt Cost of Capital

14. In mid-2012, Ralston Purina had AA-rated, 10-year bonds outstanding with a yield to maturity

of 2.05%.

a. What is the highest expected return these bonds could have?

The highest expected return we can get on these bonds is equal to the yield to maturity. Hence. highest return y=2.05%

b. At the time, similar maturity Treasuries have a yield of 1.5%. Could these bonds actually

have an expected return equal to your answer in part (a)?

No. Since, treasuries are risk free and have a yield of 1.5%, the expected return on AA rated bonds cannot not be 2.05%

c. If you believe Ralston Purina's bonds have 0.5% chance of default per year, and that expected

loss rate in the event of default is 60%, what is your estimate of the expected return for these

bonds?

y 2.05%

d 0.50%

l 60%

Expected return = y - d*l 1.7500%

Question 2

The Behavior of ...

#### Solution Summary

This solution contains step-by-step calculations to solve three questions from Corporate finance concerning the concepts of debt cost of capital, behavior of individual investors, and the efficient of the market portfolio. All steps are shown in an Excel file.