1. The stock of Milton, Inc., is expected to return 22% annually with a standard

Question

1. The stock of Milton, Inc., is expected to return 22% annually with a standard deviation of 8%. The stock of Eaton, Inc., is expected to return 24% annually with a standard deviation of 12%. The beta of the Milton stock is 1.50, and the beta of the Eaton stock is 2.2. The risk-free rate of return is expected to be 3%, but the return on the market portfolio is 14%. Based on the Security Market Line (SML), what are the required rates of return for Milton and Eaton respectively given the current market situation?

A. The required rate of return for Milton is 19.50%, and that for Eaton is 27.20%

B. The required rate of return for Milton is 24.00%, and that for Eaton is 33.80%

C. The required rate of return for Milton is 21.00%, and that for Eaton is 30.80%

D. The required rate of return for Milton is 16.50%, and that for Eaton is 24.20%

2. Continued from Question 1, which one is a better buy in the current market?

A. Milton is a better buy since the required rate of return is greater than the expected return

B. Eaton is a better buy since the required rate of return is less than the expected return

C. Eaton is a better buy since the required rate of return is greater than the expected return

D. Milton is a better buy since the required rate of return is less than the expected return

3. Technico plans to start a new product division that will have a capital structure of 60 percent debt and 40 percent equity. The levered beta for this division has been estimated to be 2.10. What will be Technico

Explanation / Answer

1. required rate of return for Milton = 3% +1.5*(14%-3%)= 19.5%

required rate of return for Eaton== 3% +2.2*(14%-3%)=27.5%

A. The required rate of return for Milton is 19.50%, and that for Eaton is 27.20%

2.

D. Milton is a better buy since the required rate of return is less than the expected return

3.

Re = 3% + 2.1*(10%)= 24%

WACC = 60%*16% + 40%*24%= 19.20%

B. 19.2%

4.

WACC = 20%*16% + 80%*18.5%= 18.00%

B. 18%

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