Question 3

(a) Explain what is meant by the Weighted Average Cost of Capital. The Charlie Corporation has 1.7 million shares of equity outstanding. The equity currently sells for 17 per share. The firms debt is publicly traded and was recently quoted at 95 per cent of face value. It has a total face value of 80 million, and it is currently priced to yield 9 per cent. The risk-free rate is 5 per cent, and the market risk premium is 11 per cent. Youve estimated that The Charlie Corporation has a beta of 1.18. If the corporate tax rate is 32 per cent, what is the weighted average cost of capital (WACC)? (12 marks) Page 6 of 6

(b) Your friend Megan has recently won 10million on the lotto. She decides to invest 9million of her winnings in the stock market. She is aware that Apple is the most valuable company in the world and is really tempted to invest the entire 9million in shares of Apple Inc. However, having recently spent a number of weeks in finance class learning about risk and expected return, you know that this is not a wise investment strategy. Explain in detail why this is the case. What would you advise she can you do in order to improve the risk/return profile of her portfolio? Use a diagram to support your answer. (10 marks)