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Finance: Expected return and Capital structuring.

1) Suppose that the Treasury bill rate were 6% rather than 4%. Assume that the expected return on the market stays at 10%. Use the betas in Table 8.2 . a. Calculate the expected return from Dell. b. Find the highest expected return that is offered by one of these stocks. c. Find the lowest expected return that is offered by one of these stocks. d. Would Ford offer a higher or lower expected return if the interest rate were 6% rather than 4%? Assume that the expected market return stays at 10%. e. Would Exxon Mobil offer a higher or lower expected return if the interest rate were 8%?

Table 8.2:

These estimates of the returns expected by investors in February 2009 were based on the capital asset pricing model. We assumed .2% for the interest rate rf and 7% for the expected risk premium rm rf .

Stock Beta (B) Expected Return [ rf ( rm rf)]

Amazon 2.16 15.4
Ford 1.75 12.6
Dell 1.41 10.2
Starbucks 1.16 8.4
Boeing 1.14 8.3
Disney .96 7.0
Newmont .63 4.7
Exxon Mobil .55 4.2
Johnson & Johnson .50 3.8
Campbell Soup .30 2.4

2) Consider a three- factor APT model. The factors and associated risk premiums are

Factor Risk Premium
Change in GNP 5%
Change in energy prices -1
Change in longterm interest rates +2

Calculate expected rates of return on the following stocks. The risk- free interest rate is 7%. a. A stock whose return is uncorrelated with all three factors. b. A stock with average exposure to each factor ( i. e., with b 1 for each). c. A pure- play energy stock with high exposure to the energy factor ( b 2) but zero expo-sure to the other two factors. d. An aluminum company stock with average sensitivity to changes in interest rates and GNP, but negative exposure of b 1.5 to the energy factor. ( The aluminum company is energy- intensive and suffers when energy prices rise.)

3)Hubbard's Pet Foods is financed 80% by common stock and 20% by bonds. The expected return on the common stock is 12% and the rate of interest on the bonds is 6%. Assuming that the bonds are default- risk- free, draw a graph that shows the expected return of Hubbard's common stock ( r E ) and the expected return on the package of common stock and bonds ( r A ) for different debt-equity ratios.

Solution Summary

The problem deals with estimating expected returns, with CAPM, and capital structuring.

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