Question
Suppose the portfolio of a large institutional investor Ace has a beta of 1.5, and the standard deviation of the rate of return on its
Suppose the portfolio of a large institutional investor Ace has a beta of 1.5, and the standard deviation of the rate of return on its portfolio is 15 percent. The portfolio of another institutional investor Yankee has a beta of 0.7. The market portfolio may be expressed as a portfolio comprising the portfolios of Ace and Yankee, and its Sharpe ratio is 0.8 Suppose there is a firm called Rusty Steel, whose stocks beta is 2 and it can borrow at the risk free rate, which is 2.5 percent. Rustys equity value is 1.5 million and its debt is 1 million. The present value of Rustys tax shield is 0.3 million. Assuming that both CAPM and the Modigliani-Miller theorem with corporate taxes hold, answer the following questions. a) What is the weight attached to Ace if we express the market portfolio as a portfolio comprising the portfolios of Ace and Yankee? [5 marks] b) What is the expected return on the market portfolio? [5 marks] c) What is the standard deviation of the rate of return on Yankees portfolio? [5 marks] d) What is the after-tax WACC of Rusty?
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