Please fill your answer in the blank box found below: You have run a regression of returns of Devonex, a machine tool manufacturer against the S&P500 index using monthly returns over the last years and arrived at the following regression equation: ReturnDevonex = -0.2% +1.5* ReturnS&P500 a) The stock had a Jensen’s alpha of 0.1% (on monthly basis) over this period. 1) Has the stock beaten the market? (2) Estimate the monthly Rf during the last 5 years. b) If the standard error of the regression beta is 0.5. Estimate the range for the regression beta at a 95% confidence interval. c) If the market risk premium is 6.5%, the tax rate is 40% and Devonex’s bonds are A rated, and the default spread for A rated bond is 1.25% 1) Estimate the cost of equity. 2) Estimate the cost of debt. 3) Estimate the WACC for Devonex if the debt ratio is 20%.

ReturnDevonex = -0.2% +1.5* ReturnS&P500

Intercept = -0.2%; Beta = 1.5

a) The stock had a Jensen’s alpha of 0.1% (on monthly basis) over this period.

1) Has the stock beaten the market? (1 mark)

Since the return on the stock = -0.2% +1.5* ReturnS&P500 > ReturnS&P500 = return on market, the stock has indeed beaten the market.

2) Estimate the monthly Rf during the last 5 years. (2 marks)

Jensen's Alpha = Intercept - Rf x (1 - Beta)

Hence, 0.1% = -0.2% - Rf x (1 - 1.5)

Hence, the monthly Rf during the last 5 years = 0.6%

b) If the standard error of the regression beta is 0.5. Estimate the range for the regression beta at a 95% confidence interval. (2 marks)

Z value for 95% confidence interval = 1.96

Hence, Lower limit of regression beta = beta - Z x standard error = 1.5 - 1.96 x 0.5 = 0.52

And the upper limit = beta + Z x standard error = 1.5 + 1.96 x 0.5 = 2.48

Hence, 0.52 < beta < 2.48

c) If the market risk premium is 6.5%, the tax rate is 40% and Devonex’s bonds are A rated, and the default spread for A rated bond is 1.25% 1) Estimate the cost of equity. (1 mark)

Annualized risk free rate, Rf = (1 + monthly rate)¹² - 1 = (1 + 0.6%)¹² - 1 = 7.44%

Cost of equity, Ke = Rf + beta x Rmp = 7.44% + 1.5 x 6.5% = 17.19%

2) Estimate the cost of debt. (2 marks)

Cost of debt, Kd = Rf + Default spread = 7.44% + 1.25% = 8.69%

3) Estimate the WACC for Devonex if the debt ratio is 20%. (2 marks)

WACC = Wd x Kd x (1 - T) + We x Ke = 20% x 8.69% x (1 - 40%) + (1 - 20%) x 17.19% = 14.80%