1. You are managing a portfolio of 10 stocks which are held in equal amounts. The current beta of the portfolio is 1.64, and the beta of stock A is 2.0. If stock A is sold, what would the beta of the replacement stock have to be to produce a new portfolio beta of 1.55? 1.1

2. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. KJM Corporation's balance sheet as of today, January 1, 2005, is as follows:

Long-term Debt (bonds, at par)	$ 10,000,000
Preferred Stock	2,000,000
Common Stock ($10 par)	10,000,000
Retained Earnings	4,000,000
Total Debt and Equity	$ 26,000,000

The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They mature on January 1, 2011. The yield-to-maturiy is 12 percent, so the bonds now sell below par. What is the current market value of the firm's debt? 6,646,453.64

3. Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have been assigned the task of choosing one of the machines. The company's cost of capital is 20 percent. Cash flow analysis indicates the following:

Year	Machine A	Machine B
0	-$2,000	-$2,000
1	0	832
2	0	832
3	0	832
4	3,877	832

1. What is the payback period of each machine? Which one should be selected if company evaluates projects using payback period method? 3.52 years and 2.40 years; choose B
2. What is the net present value of each machine? Which one should be selected if company evaluates projects by comparing their net present values? $-130.3 and $153.80; choose B
3. What is the internal rate of return of each machine? Which one should be selected if company evaluates projects by comparing their internal rates of return? 18% and 24%; choose B

4. The lower the firm's tax rate, the lower will be the firm's after tax cost of debt and WACC, other things held constant. Explain whether you agree or disagree. Disagree if the firm’s tax rate declines, the part of cost of debt paid by government will decline; after tax cost of debt will increase. As a result WACC will increase.

5. The Textbook Production Company has been hit hard due to increased competition. The company’s analysts predict that earnings (and dividends) will decline at a rate of 5 percent annually forever. Assume that k_s = 11 percent and D₀ = $2.00.

a. How much should you be willing to pay for this security? $11.875

b. If the current market price of this security is $ 9.50, what type of action will you take? BUY

c. Suppose that you purchased this security and hold it for three years. At what price do you expect to sell this security three years from now? $10.18

6. Ileri Computer has 10 percent coupon bond on the market with 15 years to maturity with a par value of $1,000. The bond makes semi-annual interest payments. The required rate of return on this bond is 12% per year.

a. Calculate the current market value of this bond. $862.35

b. Find the current yield of the bond. 11.60%

c. If next year’s rate of inflation is lower than expected, briefly discuss what you would expect to happen to the price of the bond and why. Market interest rates will decline. Value of bond will increase since present value of future cash flows increases.

7. (16 points) Dumb and Dumber Development Company has two mutually exclusive projects to evaluate. Assume both projects can be repeated indefinitely. The following cash flows are associated with each project:

Period	Project A Cash Flows	Project B Cash Flows
0	-$100,000	- $70,000
1	30,000	30,000
2	50,000	30,000
3	70,000	30,000
4		30,000
5		10,000

The project types are equally risky and the firm's cost of capital is 12 percent. If the firm evaluates projects using equivalent annual annuity (EAA), which project should be selected?