Ali has been struggling in life after being unable to survive the grueling demands of university life. Thinking back about the choices made in university days, and regretting signing up for Intermediate Finance course in Fall 2020. With online learning and Aun as the instructor, this was a bad combination and caused the inevitable of dropping out of university after failing the course. Now things had suddenly taken a turn for good through a letter announcing an inheritance of $155000 from her great grand aunt. Ali wants to make the best use of this money and want to invest this money in financial securities with a 14% return of the money. While roaming the streets in Y Block market, Ali came across Abdullah who was the TA of the unfortunate course in university days. Abdullah is now a famous investment professional. Their conversation transcript is below.

Abdullah: Hey, why are you so lost?

Ali: No, I am fine. I was just wondering about some financial plans, and I am so confused as to what should I do?

Abdullah: I guess, since it's my relevant domain, maybe I can help you in better decision making. Tell me what exactly is the dilemma?

Ali: Recently, I received $155000 as inherited money from a relative, and as far as I know, the time value of money would result in reducing the value of this amount over the years. I do not want that. I want to invest this money somewhere. Can you assist me in making a better investment decision?

Abdullah: I totally get your problem. Tell me one thing, would you like to go for a risky strategy, obviously that might give you high return or prefer a less risky investment?

Ali: I am not sure about financial plans, but I believe I would not want to take up a risky investment at the very start.

Abdullah: That makes sense. That means you should go for a diversified portfolio of financial securities so that there is less risk, and you get the desired return as well.

I would suggest you go with a mix of 2 stocks and one treasury bond.

Abdullah calls his friend, Aun who is still teaching finance at university.

Abdullah: Hey a colleague of mine wants to invest in two stocks and a treasury bond. Can you please help us find the mix that is expected to provide a good return?

Aun: Hey, Yes, sure. One of the stocks I would suggest your friend is to go with Happy Times Inc. stock. The company operates in the dyeing industry for over a decade, and it is an all-equity firm. The company had IPO 2years back, and there are currently 3.5 million shares that are being traded in the market at a price of $7 per share. Recently the company is acquiring a small competitor in the industry for $12 million, and it is expected to generate $2.75 million incremental earnings

Abdullah: That sounds interesting. What about the dividends and beta for the company?

Aun: I believe the company is expected to pay a dividend of $0.5 per share from the next year which are expected to grow at 4% there onwards. About Beta, Im sure that must be around 1.4

Also, the company is recently thinking of introducing leverage in their capital structure, and I believe the CEO, John Adams, is looking for 35:65 Debt to Equity ratio for the company. Debt can be raised at 8%.

Abdullah: That sounds interesting. What about the other stock?

Aun: The second one, which I would suggest is Braggs Textile Stock. The stock is generating returns of 12%,11%13.5%, and 11% for the past four years and is expected to perform well in the future as well. Their beta is around 0.9

Abdullah: Thanks Aun, one last bit of information Id like to know is the return on Treasury bonds these days?

Aun: The treasury bonds are generating a return of approximately 7%. The corporate tax rate is 29%.

Abdullah: This helped me a lot. Thank you so much for taking out time.

Now Abdullah has to help decide Ali; how much should be invested in all these financial securities to generate the desired return?

1. What is the cost of the capital of Happy Times when it is an only equity firm? What is the new share price after acquiring the competitor? (4 marks)

2. What is the rate of return after recalibration of the capital structure? What is the return on Braggs Textile Stock? (4 marks)

3. How much money should be invested in each stock to get the desired portfolio return, and it has only 89% of the overall market risk? (Short Selling is not allowed) (4 marks)