The Capital Market Line

Question no. 1

You are managing an equal-weighted portfolio of stocks on behalf of your company’s treasury. Assume that stock A and stock B are two risky assets. C is a risk-free asset.
The details of these stocks are below:
Stock A Stock B C (Risk-free asset rf)
Average return 7.00% 15.00% 2.00%
Variance of return 0.0064 0.0196
Sigma of return 8.00% 14.00%
Covariance of returns 0.0011

Using the information in the above stated table calculate the following:

a. Expected market portfolio return, E(RM)
b. Market excess return
c. The Sharpe ratio

Explain what information the Capital Market Line and the Security Market Line give and why they are considered useful tools in portfolio management
(250 words max).

Question no. 2
A business firm has the following details:
Annual Free Cash Flow 1,000
rU, unlevered cost of capital 20%
D, debt (perpetual) 3,000
rD, the cost of debt (interest rate) 8%
TC, corporate tax rate 40%
a. The unlevered value of the firm
b. The value of the tax shield on interest
c. The levered value of the firm
d. The cash flow to equity
(250 words max).

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