Chapter 4 Solutions (5, 8, 9, 14, 19, and 23)

Problem 5
Heav !e"h Compan has a "urrent beta o# 1$2 %ith a sto"& return varian"e ('2) o# 5()$ !he sto"& is sellin* #or +5(, do%n +4 #rom last ear$ !he "ompan paid a +2 dividend last ear and %ill (e,pe"ted) pa a +2$5( dividend this "omin* ear$ !he ta, rate is 4() #or the "ompan $ !he varian"e o# the mar&et #or this same period is 2()$ !he -.S/ "omposite (broad mar&et inde,) is do%n 8) #rom last ear and the dividend ield #or this "omposite is 3)$ Current !reasur 0ill is 3) (ris&1#ree rate) a$ 2hat is the e,pe"ted return #or Heav !e"h #or the "omin* ear3 2e %ill use the C4P5 #or this but need to #ind the mar&et ris& premium$ 6n#ortunatel the author did not provide enou*h in#ormation to #ind the mar&et premium$ 2e "ould tr the 7is"ounted 7ividend 5odel approa"h but %e do not &no% the *ro%th rate on dividends8so #rom his ans%er boo& he states %e %ill use the mar&et return premium over the ris&1#ree rate and *ives 8$9:) as the mar&et ris& premium and no% %ith the C4P5 %e have; /,pe"ted return < 3) = 1$2 (8$9:)) < 13$512) !his should be8/,pe"ted return < 3) = 1$2 (5$5)) < 9$:(), b$ 2hat %ould ou e,pe"t the pri"e to be one ear #rom no%3 ># it does return 9$:() one ear #rom no% %e "an put this into the return #ormula /(r) < (/ndin* Pri"e = 7ividends ? 0e*innin* Pri"e) @ 0e*innin* Pri"e Substitutin* the &no%n variables %e have 9$:() < (/ndin* Pri"e = +2$5( 1 +5($(() @ +5($(( 4nd %ith the ma*i" o# al*ebra %e eventuall have /ndin* Pri"e < +5( = ($(9: , +5( 1 +2$5( < +52$3( "$ 2hat %ould ou e,pe"t the return over the past ear i#, the ris&1#ree rate %as 5) and %e used the same mar&et ris& premium o# 5$5)3 /(r) < 5) = 1$2 (5$5)) < 11$:() d$ 2hat %as the a"tual return o# Heav !e"h the past ear3

Aeturn < (/ndin* Pri"e = 7ividends ? 0e*innin* Pri"e) @ 0e*innin* Pri"e Aeturn < (+5($(( = +2$(( 1 +54$(() @ +54$(( < 1+2$(( @ +54$(( < 1($(39 or 13$9) e$ /stimate the ne% beta i# Heav !e"h *oes 1(() eBuit (an unlevered #irm)$ Here the author meant to sa that the +5( million in debt %ould be retired, not the +5 million in debt #rom the problem8so 6nlevered 0eta < 0eta @ (1 = (1 ?!a, Aate) (7@/)) 6nlevered 0eta < 1$2 @ ((1 = (1 1($4() (5(@1(()) < 1$2 @ (1 = ($: , ($5) < 1$2 @1$3 < ($92 0e"ause the ne% #irm is 1(() eBuit , its beta should be ($92 the unlevered beta

Problem 8
He%lett1Pa"&ard has #our divisions and #our division betas$ !he ni"e thin* about beta is ou "an do a %ei*hted "ombination o# the betas (%ei*hts based on mar&et value o# divisions) to #ind the beta o# the #irm$ 7ivision 5ain#rames PCs So#t%are Printers !otal 5ar&et Calue 2$( 0illion 2$( 0illion 1$( 0illion 3$( 0illion 8$( 0illion 0eta 1$1( 1$5( 2$(( 1$((

a$ 2hat is the beta o# the "ompan 3 6nlevered 0eta < 2$(@8$( , 1$1 = 2$(@8$( , 1$5 = 1$(@8$( , 1$5( = 3$(@8$( , 1$(( < ($295 = ($395 = ($25 = ($395 < 1$295 -o% %ith 1$( billion o# debt the total value o# the #irm is 9$( billion$ 0e"ause the "ompan borro%s #or all divisions under the HP name %e "an allo"ate the debt evenl a"ross the #our divisions$ !he levered beta o# HP %ith a ta, rate o# 3:) and a 1@8 7@/ ratio is; Devered 0eta < 6nlevered , (1 = (1 ?!a, Aate) (7@/)) < 1$295 , (1= (1 ? ($3:) (1@8)) < 1$295 , 1$(8 < 1$399 >s this the same beta ou %ould *et b re*ressin* the HP returns on the mar&et3 Probabl not as the siEe o# the divisions have "han*ed over time and so it %ould not have the same per"enta*e invested in ea"h division ea"h ear$ ># the per"enta*e

invested ea"h ear %as the same and the 7@/ ratio %as same over time theoreti"all ou "ould *et the same beta$ b$ ># the !reasur bond rate is 9$5) (and ou are loo&in* at the lon* horiEon) estimate the "ost o# eBuit #or HP$ 4*ain %e need the mar&et ris& premium %hi"h the author states at the start o# the problems8so usin* 5$5) (e,pe"ted return o# the mar&et at 13) and premium o# 13) 1 9$5) < 5$5)) 6sin* our beta o# 1$399 the reBuired return to eBuit holders should be; Ae < 9$5) = 1$399 (5$5)) < 15$(935) 2hat about ea"h division should ou "al"ulate the reBuired return #or eBuit #or ea"h division3 First %e have to #ind ea"h divisionGs levered beta i# the ones *iven are unlevered (%hi"h %e assumed #or part a) Devered 0eta < 6nlevered , (1 = (1 ?!a, Aate) (7@/)) 5ain#rames < 1$1( , (1= (1 ? ($3:) (1@8)) < 1$1( , 1$(8 < 1$188 PCs < 1$5( , (1= (1 ? ($3:) (1@8)) < 1$5( , 1$(8 < 1$:2 So#t%are < 2$(( , (1= (1 ? ($3:) (1@8)) < 2$(( , 1$(8 < 2$1: Printers < 1$(( , (1= (1 ? ($3:) (1@8)) < 1$(( , 1$(8 < 1$(8 4nd no% the reBuired returns #or ea"h division 5ain#rames Ae < 9$5) = 1$188 (5$5)) < 14$(34) PCs Ae < 9$5) = 1$:2 (5$5)) < 1:$41) So#t%are Ae < 9$5) = 2$1: (5$5)) < 19$38) Printers Ae < 9$5) = 1$(8 (5$5)) < 13$44) "$ ># the 5ain#rame division is sold %e %ill assume it is sold at mar&et value (eBuit mar&et value plus its proportion o# the debt or 25) o# the 1 billion in debt) #or +225 billion$ !he author sa s that the +225 %as paid out as a dividend but letGs assume the portion o# the debt is also retired (be"ause ho% "an ou redu"e the eBuit value o# the other divisions3) !he "urrent value o# the #irm is no% +:$95 billion and its debt@eBuit ratio is ($95@:$( (as 25) o# the debt %as retired)$ 6nlevered beta o# HP < (2$(@:$() (1$5() = (1$(@:$()(2$(() = (3$(@:$()(1$() < 1$33 Devered 0eta < 6nlevered , (1 = (1 ?!a, Aate) (7@/)) < 1$3333 , (1= (1 ? ($3:) (($95@:$()) < 1$3333 , 1$(83498 < 1$445

Problem 9
Four Firms %ith the #ollo%in* data Compan ) Chan*e in Aevenue PharmaCorp 29) S nerCorp 25) 0io5ed 23) Sa#e5ed 21) ) Chan*e in Hp >n"ome 25) 32) 3:) 4() 0eta 1$(( 1$15 1$3( 1$4(

a$ Cal"ulate the de*ree o# operatin* levera*e #or ea"h #irm$ Hperatin* Devera*e < )Chan*e in /0>! @ )Chan*e in Sales Here /0>! is the same as operatin* in"ome and Sales is the same as Aevenue PharmaCorp Hperatin* Devera*e < ($25 @ ($29 < ($9259 S nerCorp Hperatin* Devera*e < ($32 @ ($25 < 1$28 0io5ed Hperatin* Devera*e < ($3: @ ($23 < 1$5:52 Sa#e5ed Hperatin* Devera*e < ($4( @ ($21 < 1$9(48 b$ Can ou e,plain the betas b operatin* levera*e3 First note that the *reater the operatin* levera*e the *reater the beta$ Hi*h operatin* levera*e means that the in"ome is more sensitive to "han*es in the sales$ Hi*h operatin* in"ome means hi*her #i,ed "osts (relative to variable "osts) and thus a ris&ier #irm and a hi*her beta$

Problem 14
!his problem %ants to re1establish the relationships in the statisti"s #rom a re*ression %ith the varian"es and "ovarian"es o# the random variables (here the returns o# 45A and the SIP 5(()$ a$ .ou &no% that the A1sBuared o# the re*ression is ($3: and the sto"& has a varian"e o# ($:9$ !he mar&et varian"e is ($12 so8%hat is the beta o# the sto"&3 Ae"all A2 < (beta)2 (varian"e o# mar&et) @ (varian"e o# the sto"&) Substitutin* %e have, ($3: < (beta)2 (($12) @ (($:9) 4nd rearran*in* via al*ebra %e have beta < J(($3:) (($:9) @ (($12)K1@2 < 1$4199

b$ .ou &no% that 45A did %orse than e,pe"ted b ($39 per"ent (($((39) durin* the re*ression and the ris&1#ree rate durin* the re*ression period %as 4$84)$ 2hat is the inter"ept o# the re*ression3 !his Buestion is not "orre"t statisti"all spea&in*$ 4 "ompan "an not under per#orm in a re*ression$ 2hat the author should have done %as to *ive ou the avera*e return o# the t%o assets over this period$ DetGs assume that the mar&etGs avera*e return %as 13$5) and the avera*e return #or 45A %as 18$95)$ -o% #ind the inter"ept o# the re*ression *iven the beta o# 1$4199 in part a8 >nter"ept < (mean o# the 45A) ? (beta) (mean o# mar&et) >nter"ept < (($1895) ? (1$4199) (($135) < 1 ($((39 or 1 ($39) "$ 4nother #irm has an A1sBuared o# ($48 (> thin& he meant ($3: other%ise this Buestion does not ma&e sense)8%ould the t%o #irms have the same beta3 !he ans%er is no8the beta is a #un"tion o# "ovarian"e o# ea"h "ompan and the mar&et %hile the A1sBuared is a #un"tion o# the varian"e o# ea"h "ompan and the mar&et$ !hin& o# this as a proo#8 A2i < (L1) ('2i) @ ('25) So (L 1) ('21) @ ('25) < (L 2) ('22) @ ('25) 4nd (L 1) ('21) < (L 2) ('22) So i# L1 < L2 then ('21) < ('22) 8and %e do not &no% this8

Problem 19
!r in* to estimate the beta o# a private "ompan 8this is "alled pure pla 8 Hther home applian"e manu#a"turin* "ompanies that are publi" have the #ollo%in* beta, debt, and eBuit 8 Compan 0la"& and 7e"&er Fedders 5a ta* -ational Presto 2hirlpool 0eta 1$4( 1$2( 1$2( ($9( 1$5( 7ebt +2,5(( +5 +54( +8 +2,9(( /Buit +3,((( +2(( +2,25( +3(( +4,(((

a$ /stimate the beta o# a private "ompan %ith a debt1eBuit ratio o# 25) and a ta, rate o# 4()$ !hese #irms also have a ta, rate o# 4()$

Hne %a is to "ompute the unlevered betas o# ea"h o# the #ive #irms and then avera*e these unlevered betas and substitute it as the unlevered beta o# the private "ompan 8 6nlevered 0eta < 0eta @ (1 = (1 ?!a, Aate) (7@/)) 0la"& I 7e"&er < 1$4 @ (1= (11($4() (2,5((@3,((() < ($9333 Fedders < 1$2 @ (1= (11($4() (5@2(() < 1$1823 5a ta* < 1$2 @ (1= (11($4() (54(@2,25() < 1$(49( -ational Presto < ($9 @ (1= (11($4() (8@3(() < ($:89( 2hirlpool < 1$5 @ (1= (11($4() (2,9((@4,((() < 1$(453 4vera*e 6nlevered 0eta < (($9333 = 1$1823 = 1$(49( = ($:89( = 1$(453) @ 5 4vera*e 6nlevered 0eta < 4$8989 @ 5 < ($9998 Devered beta o# private #irm < ($9998 (1= (1 ? ($4() (1@4)) < 1$12:8 b$ 2hat are our "on"erns on usin* this approa"h3 First, the %ide ran*e o# betas in the industr ma&es it hard to Musti# a point estimate o# the beta o# the private #irm$ Se"ond, the debt@eBuit ratios and siEe o# these var and it %ould probabl be better to #ind a #irm similar in siEe and debt@eBuit #undin* #or the private #irm and Must use that beta$

Problem 23
Doo& at !i##an Gs in#ormation and estimate its beta based on the industr 8 .ou &no% that re*ression estimate o# the beta is ($95 and the standard error #or the beta is ($5($ .ou also note that the avera*e unlevered beta o# "omparable spe"ialt retailin* #irms is 1$15$ a$ ># !i##an Gs has a d@e ratio o# 2(), estimate the beta #or the "ompan based on "omparable #irms usin* a 4() ta, rate8 0eta < 6nlevered 0eta (1 = (1 ?!a, Aate) (7@/)) 0eta o# !i##an Gs < 1$15 (1= (11($4)(1@5)) < 1$288 b$ /stimate a ran*e #or the beta #rom the re*ression8

Here %e must assume that %e have a desired ran*e, %hi"h is %ithin one standard deviation o# the mean estimate8or t%o standard deviations o# the mean8 Hne standard deviation ran*e; ($95 ? (($5() to ($95 = (($5() < ($25 to 1$25 !%o standard deviation ran*e; ($95 ? 2(($5() to ($95 = 2(($5() < 1($25 to 1$95 !he one standard deviation ran*e has a "on#iden"e interval o# :9) and the t%o standard deviation mean has a "on#iden"e interval o# 95)$ "$ 4ssume !i##an Gs has a triple 0 ratin* and the spread is 1 per"ent above the !1 bond rate o# :$5)$ /stimate the "ost o# "apital #or !i##an $ -eed the mar&et ris& premium (use 5$5) as spe"i#ied at the start o# the problems) Cost o# /Buit usin* the ($95 beta < :$5) = ($95 (5$5)) < 1($:25) Cost o# 7ebt < :$5) = 1$() < 9$5) Cost o# Capital (24CC) < 5@: (1($:25)) = 1@: (9$5)) (1 ? ($4() < 8$8542 ) = ($95) < 9$:(42) 2here does the 5@: and 1@: "ome #rom in the 24CC3 Ae"all the debt1eBuit ratio is 2() or 1@5$ ># %e set / < 5 and 7 < 1 then in the 24CC %e have /@C < 5 @ (5 =1) and 7@C < 1 @ (5=1) or 5@: and 1@:8