Suppose there exists two firms, A and B in Kenyan financial market which are identical in all respects except the use of debt. Firm A is an all equity financed firm, with 3,000,000 dollars equity capital; while firm L employs 600,000 dollars debt at a 15 per cent rate of interest. Both firms have expected earnings before interest and taxes of 25,000 dollars, pay corporate tax at 25% and distribute 100% earnings as dividends to shareholders. Both shareholders and lenders are required to pay 30% tax on their income As a financial analyst determine the total income to investors and interest tax shield for levered, L, and unlevered, U, firms.

Q TWO: (A company has invested in three assets: large company stocks, small capitalization stocks and international stocks in equal proportions. The Expected return values for these three assets are

Large Co Stocks Small Cap Stocks International Stocks

12.09% 17.83% 14.95%

The Variance- covariance matrix V for these three assets is

{246.80 266.97 135.28}

{266.97 462.72 146.64}

{135.28 146.64 321.84}

Using Excel functions

(i) the expected portfolio return

(ii) portfolio risk