Exercise 3 (40 points):

You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns:

year risk-free return market return XYZ return

2007 3% 6% 10%

2008 1% -37% -45%

a. What was XYZs average historical return?

b. Compute the markets and XYZs excess returns for each year. Estimate XYZs beta.

c. Estimate XYZs historical alpha.

d. Suppose the current risk-free rate is 2%, and you expect the markets return to be 9%. Use the CAPM to estimate an expected return for XYZ Corp.s stock.

e. Would you base your estimate of XYZs equity cost of capital on your answer in part (a) or in part (d)? How does your answer to part (c) affect your estimate? Explain.