PART A

1. For each of the following determine a benchmark (from the case) and justify your choice:

T Rowe Price Blue Chip Growth (TRBCX)

Goldman Sachs CORE Large Cap Growth (GLCGX)

Russell 1000 Growth: This index is a strong benchmark for the GLCGX fund
because the fund seeks growth companies with strong and predictable cash flows
and dividends, and the index is made up of larger companies with high price-tobook ratios, strong earnings, and high forecasted growth values. This includes
technology, consumer, discretionary spending, and consumer staples industry
verticals.

Diversified Special Equity Inv (DVPEX)

S&P 500: Because this index represents 500 largest companies by market
capitalization, it represents a fair benchmark for a fund built around leading
market firms, seasoned management, and strong financial fundamentals.

Russell 2000: This index is the most common for mutual funds that identify
themselves as small cap. The DVPEX fund does not consider dividends, but
instead focuses highly companies with a market capitalization value of under $2
billion.

DFA Tax-Managed U.S. Small Cap Value (DTMVX)

Russell 2000 Value: DFA funds focus on value firms and small cap stocks. This
is a perfect benchmark for DTMVX as it invests in small companies with high
book-to-market ratios.

2. Based on the chosen benchmarks, how did each fund perform in the period from January 2000
through December 2004? Would you recommend buying any of the funds? If so, which?

Based on the chosen benchmarks, each fund performed as described below from January 2000
through December 2004. It seems as though TRBCX and DTMVX outperformed their
benchmark index, while GLCGX and DVPEX did not.

We would for sure recommend buying the DTMVX fund due to the strong relative performance
and the fact that the return over this period was positive. In addition, we would recommend
buying DVPEX due to the decent positive return over this period, despite the fact that it very
slightly underperformed with relation to the index.

3. For each of the 4 mutual funds in (1), use the CAPM to evaluate the performance of the fund
manager for the period from January 2000 through December 2004. Based on your findings,
would you recommend buying any of the funds?

We determined our betas using a one factor linear regression using the market premium as
the x variable and the fund return minus the risk free rate as our y variable. We used
monthly values for our inputs. We utilized the benchmark index to represent the market
and long-term government bonds as our risk free rates.

Using the CAPM equation and our determined betas, we found expected returns for the
funds. As the market was volatile and data varied highly between months, it was very hard
to determine a monthly estimation for returns, and so we annualized all of the returns by
finding the period returns and then converting them to compound annual growth rates.

We found that just the T Rowe Price Blue Chip Growth (TRBCX) fund outperformed the
expected CAPM return, and so they had positive alpha values, while the other three funds
had negative alpha values. Based solely on the comparison between the funds alpha values,
we would suggest purchasing the TRBCX fund; however, during this time frame, we might
not have purchased this fund and may have been more attracted to other funds (despite
underperforming their prospective indices) due to the economic environment favoring
certain kinds of companies and harming others.

4. Do the same as in (3), but now use (a) the Fama French 3 Factor Model, and (b) the Fama French
3 Factor Model plus the Momentum Factor. Based on your results, does it look like any of the
fund managers have stock picking skill?

Utilizing a similar methodology as our construction of the CAPM equation, we

estimated expected returns using the Fama French 3 Factor Model and the Fama
French 3 Factor Model plus the Momentum Factor.
a) Utilizing the Fama-French 3 Factor Model which uses a market factor, a small minus big
stock factor, and a high book-to-market minus low book-to-market factor, we found that
all four funds outperformed the calculated expected returns.
b) When we added the momentum factor to the model we still found that all four funds
outperformed the calculated expected returns.

Based on these results, it seems as if 4 of the fund managers have stock-picking skill.

5. Can you think of a way to use the industry portfolios to do something like problems (3) and (4)?
If so, how do your results compare?
Yes, you could run regressions on industries that tend to have companies of certain sizes
and relative values. We ran the following regressions to see if these industries were a
good predicting measure of fund performance:
T Rowe Price Blue Chip Growth (TRBCX)

Blue Chip: Average of Consumer Durables, Manufacturing, and

Energy

Goldman Sachs CORE Large Cap Growth (GLCGX)

Diversified Special Equity Inv (DVPEX)

Historically Small Cap?: Consumer Non-Durables (shot in the dark)

DFA Tax-Managed U.S. Small Cap Value (DTMVX)

Growth: Average of Hi-Tech and Telecom

Value: Utilities

We looked the R^2 value of the results to determine if these industries were correlated
enough to predict fund returns. The Blue Chip vs. TRBCX and the Growth vs.
GLCGX regressions had R^2 values over .40, which makes the X variables relatively good
estimations for a beta that can reasonably predict fund return. Our growth industry R^2
was our highest at .85! For these two CAPM equations, we got a negative alpha. This
would conclude that the funds underperformed their respective markets.

PART B
1. Using whichever model(s) you deem appropriate, estimate the cost of capital for Yahoo (YHOO)
and Altria (MO) in December 2004. At that time, the yield on the 10 year and 30 year U.S.
government bonds was 4.2% and 4.9%, respectively. Both firms have opportunities to make new
investments that are broadly similar to their existing assets and are expected to produce an equity
return of 10% per year. The investments would be financed with the same historical mix of debt
and equity. In other words, focusing directly on the cost of equity is sufficient. No unlevering or
relevering is necessary.
2. How do the costs of capital that you estimate compare to those of the projects? Would you give
these projects the green light?

We ran a regression between recent 5 year performance of these stocks, Yahoo and
Altria, and their respective industries, Telecom and Consumer Nondurables. We
utilized future-looking data by using the 10-year yield at the end of 2004 for our riskfree rate and used an industry historical return (using the 40 year data) to estimate
expected a forward-looking market return (this provides a smoother, more accurate
market prediction [the telecom industry would have been tainted by the dotcom bubble
and there was a recession during this time frame as well]).
We calculated effective cost of equity for Yahoo to be 20.68% and for Altria, 23.05%.
Given this high cost of equity, unless the companies have capital structures that are
levered enough to produce an overall WACC of less than 10%, these projects would
not be profitable and should not be taken on.