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# Corporate Investment Analysis

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8). As an equity analyst, you have developed the following return forecasts and risk estimates for two different stock mutual funds (Fund T and Fund U):

Forecasted
Return CAPM
Beta
Fund T 9.0 1.20
Fund U 10.0 .80

a). If the risk-free rate is 3.9% and the expected market risk premium (i.e., E(RM) - RFR) is 6.1%, calculate the expected return for each mutual fund according to the CAPM.

b). Using the estimated expected returns for Part a along with your own return forecasts, demonstrate whether Fund T and Fund U are currently priced to fall directly on the security market line (SML), above the SML, or below the SML.

c). According to your analysis, the Funds T and U overvalued, undervalued, or properly valued?

10). Draw the security market line for each of the following conditions:
a). (1) RFR = 0.08; RM(proxy) = 0.12
(2) Rz = 0.06; RM(true) = 0.15

b. Rader Tire has the following results for the last six periods. Calculate and compare the betas using each index.
RATES OF RETURN
(%) Proxy Specific Index (%) True General Index (%)
1 29 12 15
2 12 10 13
3 -12 -9 -8
4 17 14 18
5 20 25 28
6 -5 -10 0

c). If the current period return for the market is 12% and for Rader Tire it is 11%, are superior results being obtained for either index beta?

#### Solution Summary

8). As an equity analyst, you have developed the following return forecasts and risk estimates for two different stock mutual funds (Fund T and Fund U):

Forecasted
Return CAPM
Beta
Fund T 9.0 1.20
Fund U 10.0 .80

a). If the risk-free rate is 3.9% and the expected market risk premium (i.e., E(RM) - RFR) is 6.1%, calculate the expected return for each mutual fund according to the CAPM.

b). Using the estimated expected returns for Part a along with your own return forecasts, demonstrate whether Fund T and Fund U are currently priced to fall directly on the security market line (SML), above the SML, or below the SML.

c). According to your analysis, the Funds T and U overvalued, undervalued, or properly valued?

10). Draw the security market line for each of the following conditions:
a). (1) RFR = 0.08; RM(proxy) = 0.12
(2) Rz = 0.06; RM(true) = 0.15

b. Rader Tire has the following results for the last six periods. Calculate and compare the betas using each index.
RATES OF RETURN
(%) Proxy Specific Index (%) True General Index (%)
1 29 12 15
2 12 10 13
3 -12 -9 -8
4 17 14 18
5 20 25 28
6 -5 -10 0

c). If the current period return for the market is 12% and for Rader Tire it is 11%, are superior results being obtained for either index beta?

\$2.19

## Corporate Bond Analysis and Valuation

Corporate Bond Analysis and Valuation
Jill Dougherty was hired as an investment analyst by A.M. Smith Inc. for the Cincinnati, Ohio
office based on her sound academic credentials, which included an MBA from a top ranking
university and a CFA designation. At the time for her recruitment she was told that one of her
responsibilities would be to conduct educational seminars for current and prospective clients.
A.M. Smith Inc., a prestigious investment services firm, with branches in 30 major
metropolitan areas, had achieved most of its success due to its excellent client relations and focus
on client support. The firm ranked among the very best in terms of the number of successful
equity underwriting deals undertaken. Recently, a large utility company had hired it as the leading
investment banker for a major corporate bond issue. Since most of its retail customers were more
familiar with stock investment, John Sullivan, the branch manager at the Cincinnati office, asked
Jill to prepare and present a seminar outlining the various implications of fixed income
investments. "About 60% of our investors are in the 55+ age group, Jill, so we should not have
much trouble convincing them of the benefits of investing in bonds" remarked John. "However,
they may need clarifications regarding various terms and concepts associated with fixed income
investing. Your job is to convince them of the relative safety and income potential of corporate
bonds" said John.
In preparation for the seminar, Jill called up a few of her best clients and queried them
regarding their awareness of the risk and return potential associated with corporate bond
investments. She realized that apart from a good knowledge about the current level and stability
of interest rates and inflation, most customers were not very familiar about the finer aspects of
bond investing. Bond features like callability, convertibility, sinking fund provision, bond ratings,
debentures, interest rate risk, etc. were not well understood by most of the clients she interviewed.
Most of them seemed awfully interested in knowing more about the opportunities offered by bond
investing and Jill knew that she would have a good turnout at the seminar. She decided to refer
back to her Finance textbook and dig out some definitions and examples that she could use in her
maturities, ratings, and coupon rates (see Table 1) and started preparing her slides.
Table 1
Corporate Bond Information
Issuer Face
Value
Coupon
Rate
Rating Quoted
Price
Years until
Maturity
Sinking
Fund
Call
Period
ABC Energy \$1,000 5% AAA \$703.1 20 Yes 3 Years
ABC Energy \$1,000 0% AAA \$208.3 20 Yes NA
TransPower \$1,000 10% AA \$1,092.0 20 Yes 5 Years
Telco Utilities \$1,000 11% AA \$1,206.4 30 No 5 Years
Questions:
1. How should Jill go about explaining the relationship between coupon rates and bond prices?
Why do the coupon rates for the various bonds vary so much?
2. How are the ratings of these bonds determined? What happens when the bond ratings get