Portfolio and Capital Estimation Calculations ✓ Solved

Portfolio and Capital Estimation Calculations

A portfolio manager has a $10 million portfolio, which consists of $1 million invested in 10 separate stocks. The portfolio beta is 1.2. The risk-free rate is 5% and the market risk premium (rM-rRF) is 6%. What is the portfolio’s required return?

After the manager sells one of the stocks in her portfolio for $1 million (with a beta of 0.9) and purchases a new stock (with a beta of 1.6), what is the required return of her portfolio after this transaction?

Central Development Company just paid a dividend of $3.00 per share and expects the dividend to grow 15% annually for the next three years, then at 2% thereafter. Considering a risk-free rate of 2.5%, a market risk premium of 6.5%, and a beta of 1.5, how much would you be willing to pay for Central's stock today? What will you be able to sell it for at the end of year 4?

Angell Inc. has a target capital structure of 40% debt, 15% preferred, and 45% common, with a tax rate of 25%. The before-tax cost of debt is 0%, the cost of preferred stock is 7.5%, and the cost of retained earnings is 74%. If Angell Inc. uses retained earnings, what is its WACC? If it raises new common equity, how much higher will the WACC be?

Paper For Above Instructions

To determine the required return of a portfolio, we can use the Capital Asset Pricing Model (CAPM). According to CAPM:

Required Return = Risk-Free Rate + Beta × Market Risk Premium

Using the data provided, we can find the portfolio’s required return as follows:

Risk-Free Rate = 5%

Market Risk Premium = 6%

Portfolio Beta = 1.2

Plugging in these values:

Required Return = 5% + (1.2 × 6%) = 5% + 7.2% = 12.2%

Next, regarding the situation where the manager sells one stock and buys another, we need to recalculate the beta of the new portfolio. The beta of the newly formed portfolio is computed as follows:

Original Stock Beta: 0.9 (sold)

New Stock Beta: 1.6 (purchased)

Remaining Portfolio Beta Calculation:

New Portfolio Beta = (Old Portfolio Value × Old Beta - Sold Stock Value × Sold Stock Beta + Purchased Stock Value × New Stock Beta) / New Portfolio Value

New Portfolio Beta = [($10,000,000 × 1.2 - $1,000,000 × 0.9 + $1,000,000 × 1.6) / ($10,000,000)]

Calculating this gives us:

New Portfolio Beta = [($12,000,000 - $900,000 + $1,600,000) / $10,000,000]

= (($12,700,000) / $10,000,000) = 1.27

Now, we can find the required return of the new portfolio with the updated beta:

Required Return = 5% + (1.27 × 6%) = 5% + 7.62% = 12.62%

Now, moving to Central Development Company calculations: To find out how much to pay for the stock today, first, we need to calculate the present value of expected dividends.

First three years’ dividends growth = 15%

D1 = $3.00 × (1 + 15%) = $3.45

D2 = $3.45 × (1 + 15%) = $3.97

D3 = $3.97 × (1 + 15%) = $4.56

For the subsequent growth of 2% forever:

D4 = $4.56 × (1 + 2%) = $4.65

To value the stock today, we calculate the present value of all dividends:

PV = D1/(1+r)^1 + D2/(1+r)^2 + D3/(1+r)^3 + (D4/(r-g))/(1+r)^3

Where g = growth rate after year 3, r = required return based on CAPM.

Calculating the required return first:

Risk-Free Rate = 2.5%

Market Risk Premium = 6.5%

Beta = 1.5

Required Return = 2.5% + (1.5 × 6.5%) = 2.5% + 9.75% = 12.25%

Now substituting into the PV formula:

PV = $3.45/(1+0.1225)^1 + $3.97/(1+0.1225)^2 + $4.56/(1+0.1225)^3 + $4.65/(0.1225-0.02)/(1+0.1225)^3

This gives:

PV ≈ $3.07 + $3.15 + $3.26 + $33.51 = $42.99

In year four, you will be able to sell the stock at D4 (expected sale price) that you calculated which is around $4.65. Thus, the stock price at the end of year 4 will be $4.65.

Lastly, for Angell Inc., calculating WACC:

WACC = (E/V) Re + (D/V) Rd (1-Tc) + (P/V) Rp

Where:

E = market value of equity

D = market value of debt

P = market value of preferred stock

V = total market value (E + D + P)

Re = cost of equity

Rd = cost of debt

Rp = cost of preferred stock

Tc = corporate tax rate

Assuming total market equity value of $4.5 million, then:

WACC = (0.45 0.74) + (0.40 0.00 (1-0.25)) + (0.15 0.075) = 0.333 + 0 + 0.01125 = 34.4%

If new equity was raised, with higher costs, the WACC can be calculated accordingly based on what the costs escalate to but generally would see an increase in the WACC of approx 0.5% to 1%.

References

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