Suppose a large institutional investor Zeta’s portfolio has a beta of 1.6. Another institutional investor Kappa’s portfolio has a beta of 0.6. Both portfolios have the same Sharpe ratio as that of the market portfolio, which is 0.8, and the standard deviation of Zeta’s portfolio is 15 percent. Suppose there is a firm called Cunning corporation, whose stock’s beta is 2 and it can borrow at the risk free rate, which is 3 percent. Cunning’s equity value is £1.2 million and its debt is £1 million. The present value of Cunning’s tax shield is £0.35 million. Assuming that both CAPM and the Modigliani-Miller theorem with corporate taxes hold, answer the following questions.
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a) What is the expected return on Zeta’s portfolio?
b) What is the expected return on the market portfolio?
c) What is the weight attached to Kappa if we express the market portfolio as a portfolio comprising Zeta and Kappa’s portfolios?
d) What is the after-tax WACC of Cunning?