Stock market Rate and Return

Question 1: Stock market Rate and Return. (2 marks each, total 18 marks)

Instructions:

  1. You must complete the assignment individually. Any collusion will lead to a zero mark and will be reported to the academic office.
  2. The data source and reference must be in APA format.
  3. All the sub questions (expect part 1) must include definition, calculation and comments. For example, the pros and cons of a method, critics of a model or a theory. You must write in complete sentences and paragraphs, minimum 2 paragraphs for each sub-question.

Assume that you recently graduated with an MBA degree and have just landed a job as a financial planner with Henry’s Investment Inc. Your first assignment is to create a portfolio for a client by selecting two stocks on the market.

  1. You need to complete the below table by selecting ANY two stocks (except for Microsoft) on Nasdaq and collect the data on Dec 31 each year (or the last trading day in that year):
                Company 1’s Name              Company 2’s NameNasdaq Composite Includes Dividends
YearStock Price  Dividend (paid in the last quarter as of the year)Stock PriceDividend (paid in the last quarter as of the year)
2019     
2018     
2017     
2016     
2015     
2014     
  • Use the data you have collected to calculate annual returns for Company 1, Company 2, and the Market Index, and then calculate average returns over the five-year period.  Give comments on your calculation results. Which stock has a higher return?
  • Calculate the standard deviation of the returns for Company 1, Company 2, and the Market Index. Do you think the standard deviation can reflect the stocks’ risks? And why?
  • Construct a scatter diagram graph that shows Company 1’s and Company 2’s returns on the vertical axis and the Market Index’s returns on the horizontal axis.  What’s the relationship between the two stocks from your observation?
  • Estimate or use data to find Company 1’s and Company 2’s betas,  as the slopes of regression lines with stock returns on the vertical axis (y-axis) and market return on the horizontal axis (x-axis).  Are these betas consistent with your graph? Do you think beta can reflect the stocks’ risks? And why?
  • You need to determine the risk-free rate.  What will be your approach and why do you select this method? How much the rate will be?
  • What’s the market risk premium? Assume that the market risk premium is 5.5%.  What is the expected return on the market?  Use the SML equation to calculate the two companies’ required returns.
  • If you formed a portfolio that consisted of 50% Company 1 stock and 50% Company 2 stock, what would be its beta and its required return? How will the portfolio hedge the risk?
  • Suppose an investor wants to include any one of the two stocks that you recommended in his or her portfolio.  Stocks A, B, and C are currently in the portfolio, and their betas are 0.869, 1.985, and 1.02, respectively.  Recommend a stock from the two stocks you’ve selected to her/him and calculate the new portfolio’s required return if it consists of 25% of the company you’ve recommended, 15% of Stock A, 40% of Stock B, and 20% of Stock C. Give your comments to risk of the new portfolio. Do you recommend it or not? And why?

Question 2: WACC Estimation (the questions was referenced and revised from Financial Management textbook of Nelson Publishing)

The balance sheet for Aurora Equipment Implements Inc is provided below along with other selected financial data.

Balance Sheet as at December 31, 2020 ($ millions)

Cash$10     Accounts payable$10
Accounts Receivable20     Accruals10
Inventory20     Short term debt5
Total current assets50     Total current liabilities25
    
        Long-term debt20
    
Plant and equipment (net)38     Preferred stock                        3
       Common equity10
       Retained earnings30
Total Assets$88     Total liabilities and equity$88
    

The facts given:

  1. Short term debt consists of bank loans that currently cost 10%, with interest payable quarterly. These loans are used to finance receivables and inventories in a seasonal basis, so in the off-season, bank loans are zero.
  2. The long term debts consist of 20-years, semi-annual payment mortgage bond with a coupon rate of 8%. Currently these bonds provide a yield to investors of rd=7%. Of new bonds were sold, they would yield investors 7%.
  3. The firms’ perpetual preferred stock has a $25 par value, pays a quat4rly dividend of $0.45, and has a yield to investors of 6.5%. New perpetual preferred would have to provide the dame yield to investors and the company would incur a 5% flotation cost to sell them.
  4. The company has 4 million shares of common stock outstanding. P0=$20, but the stock has recently traded in the range od $17 to $23. D0=$1 and EPS0=$2. ROE based om average equity was 24% in 2015, but management expects to increase this return on equity to 30%; however security analysists are nor aware of management’s optimism in this regards.
  5. Betas, as reported by security analyst, range from 1.7 to 1.7; the government bond rate is 5%. Brokerage house reports forecast growth rate in the range of 4% to 8% over the forecastable future. However, some analysis does not explicitly forecast growth rates, but they indicate to their clients that they expect Aurora’s historical trends. As shown in the table in fact (9), to continue.
  6. At a recent conferences, Aurora’s financial vice president polled some pension fund investment managers on the minimum rate of return they would have to expect pm Aurora’s common to make them willing to buy the common rather than Aurora bonds, when the bonds yield 7%. The responses suggested a risk premium over Aurora bonds of 3 to 5 percentage points.
  7. Aurora in in the 30% tax bracket.
  8. Aurora principal investment banker, J&J Company predicts a decline in interest rats, with rd falling to 6% and the government bond rate to 4%, although J&J acknowledge that an increase in the expected inflation rare could lead to an increase rather than a decrease in rates.
  9. Here is the historical record of EPS and DPS.
YearEPSDPSYearEPSDPS
2006$0.09$0.002014$0.78$0.00
2007-0.20.0020150.800.00
20080.400.0020161.200.20
20090.520.0020170.950.40
20100.100.0020181.300.60
20110.570.0020191.600.80
20120.610.0020202.001.00
20130.700.00   

Assume that you are a recently hired financial analysist and that your boss, the treasurer, has asked you to estimate the company’s WACC. Assume no new equity will be issues. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the firm’s average assets now on the books.

Write a report including the overall WACC calculation ( 4marks) , the rational of WACC different  (2 marks), approaches in estimating equity costs different  (2 marks), the common mistakes people make when estimating WACC , the pros and cons (2 marks),, and give your comments on Aurora’s capital structure(2 marks).

The data source and reference must be in APA format.

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