Homework answers / question archive / The following table details an analyst’s prediction of the probabilities of different states of the market over the next year, along with the forecast returns on security A and security B in each different market states given in the table below

The following table details an analyst’s prediction of the probabilities of different states of the market over the next year, along with the forecast returns on security A and security B in each different market states given in the table below

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The following table details an analyst’s prediction of the probabilities of different states
of the market over the next year, along with the forecast returns on security A and
security B in each different market states given in the table below.

Securities → A B
Market States↓ Probability Return Return
Very good 0.2 29% 14%
Good 0.4 13.5% 17.5%

Average 0.3 11.5% 10.5%

Bad 0.1 -8% 3%

Required:

 

(a) Calculate the expected returns and standard deviation of returns on security A and
security B.
(b) Calculate the covariance of returns between securities A and B.
(c) Calculate the correlation co-efficient of securities A and B.
(d) Discuss the importance of correlation co-efficient between returns of assets in
forming a portfolio.

Question 2:

Following information is available about AOI Ltd.
Statement of financial performance extract
Liabilities
10% debentures ($100 par, coupon-annual) $11,000,000
Shareholders’ funds
Ordinary shares ($1 par) $30,000,000
11% preference shares ($10 par) $6,000,000
Additional information
• An interest payment in relation to the debentures has just been made, and the debentures
mature four years from today. The market rate of interest on the debentures is 12%.
• The preference shares are trading on the market at $10.00 each, and a dividend of 110¢
per share has just been paid.
• Forecasts in relation to market returns are as follows: expected risk-free rate of return
= 6%; expected return on the market portfolio = 16.50%; and the systematic risk of
AOI’s ordinary shares represented by its beta is 1.25. These shares are trading on the
market at $2.50 each.
• No company or personal taxes are levied.
• The existing capital structure is unlikely to change.
Required:
(a) Calculate the market value of each of the sources of capital.
(b) Calculate the total market value of the firm.
(c) Calculate the weight/ proportion of each of the sources of capital to total market
value of the firm.
(d) Calculate/determine the cost of each of the sources of capital.
(e) The weighted average cost of capital (WACC) of AOI Ltd based on the market
values of the sources of capital.

Question 3:

a) Provide an intuitive explanation of the fundamental proposition of Modigliani and
Miller (M&M) pertaining to a firm’s capital structure in a world without taxes (and
other frictions) and with perfect capital markets?

b) Discuss your arguments against M&M’s capital structure irrelevance proposition in the
real world situation.

c) XYZ company just announced a final dividend of 40 cents per share. The interim
dividend for the year was paid 35 cents per share. Both the dividends are fully franked
with the company tax rate of 30%. You hold 70,000 shares of the company and are
entitled to both the dividends. What is the taxable amount of dividend to be included in
your tax return? How much franking credit will you receive, assuming you have the highest tax rate of 45%