CORPORATE FINANCE. TUTORIAL 6.

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CORPORATE FINANCE. TUTORIAL 6.

© All Rights Reserved

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Question 1:

True or False?

(a) The CAPM implies that if you could find an investment with a negative beta,

its expected return would be less than the risk-free interest rate. TRUE. r = Rf

+ b * (Rm Rf), where Rf risk-free rate, Rm return on the market. If b is negative,

then r < Rf given that (Rm Rf) is positive.

(b) The expected return on an investment with a beta of 2.0 is twice as high as

the expected return on the market. - FALSE. See formula for r above.

(c) If a stock lies below the CAPM line, it is undervalued. - FALSE. If a stocks

expected return < the required return per CAPM, the stock is overvalued relative to

the market i.e. the lower discount rate produces higher value, all else equal.

Question 2:

The Treasury bill rate is 4%, and the expected return on the market portfolio is 9%. On

the basis of the capital asset pricing model:

a

Draw a graph showing how the expected return varies with beta.

-2%

0%

2%

4%

6%

8%

The premium to compensate investors for the risk of investing in the stock. Its

difference between the predictable return on a market portfolio and the risk-free

rate. Market risk premium is equal to the slope of the security market line (SML).

What is the required return on an investment with a beta of 1.5?

Rf

b

4%

1.5

10%

(Rm-Rf)

r

d

5%

11.5%

have a positive NPV?

Given Rf = 4%, expected return on the market portfolio = 9%, expected return =

7.7%, and beta = 0.8, the calculated return on the market = 8.6%. Since stocks

expected return (7.7%) < return on a market portfolio (8.6%), the valuation of the

stock will have positive NPV because of lower discount rate.

If the market expects a return of 8.3% from stock X, what is its beta?

4% RISK-FREE RATE

5% RISK PREMIUM

EXPECTED

8.3% RETURN

b

0.9

Question 3:

The expected return on a stock is frequently written as R i = a + *Rm, where Rm is the

return on the market and is the stocks beta. The capital asset pricing model says that

in equilibrium

(a) a=0

(b) a = Rf (the risk-free rate of interest)

(c) a = (1-)*Rf

(d) a = (1-Rf)

Which is correct?

Answer: (c). r = Rf + b * (Rm Rf), where Rf risk-free rate, Rm return on the market.

Question 4:

You are given the following information for Cicione&Co.

Long-term debt outstanding: $300,000 Current yield to maturity (R d) 8% Number of

shares of common stock 10,000 Price per share $50 Book Value per share $25 Expected

rate of return on stock (Re) 15%

a

Calculate Ciciones company cost of capital (Ra). Assume there are no taxes.

b

How would Re and the cost of capital change if Ciciones stock price rises to

$75 due to surge in profits? Business risk is unchanged.

Answer: WACC = 15%.

Question5:

a

Assuming that the debt of the competitors is risk-free, estimate the asset beta

for each of Amalgamateds division.

(equity):

FOOD = 0.56, ELECTRONICS = 1.28, CHEMICALS = 0.72.

The following firms betas are the best estimates for Amalgamated Products food,

electronics, and chemicals divisions betas: United Foods, General Electronics,

Associated Chemicals.

(b) Amalgamateds ratio of debt to assets is 0.29. If your estimates of divisional

betas are right, what is Amalgamateds equity beta?

Amalgamateds beta (asset) = 0.29*0% + 0.71*(0.5*0.56+0.3*1.28+0.2*0.72) = 0.57

(given risk-free debt).

Beta (asset) = D/(D+E)*Beta (debt) + E/(D+E)*Beta (equity) =>

Beta (equity) = 0.57/0.71 = 0.81.

(c) Assume that the risk-free interest rate is 7%. And that the expected return

on the market index is 15%. Estimate the cost of capital for each of

Amalgamateds divisions.

COST OF EQUITY

Beta

Premium Rf+b*Premium

0.56

8%

11%

FOOD

ELECTRON

ICS

1.28

8%

17%

CHEMICAL

S

0.72

8%

13%

Assuming risk-free debt, cost of equity = cost of capital. The following firms betas

are the best estimates for Amalgamated Products food, electronics, and chemicals

divisions betas: United Foods, General Electronics, Associated Chemicals.

(d) How much would your answers to parts (a)-(c) change if you assumed

instead that Amalgamateds debt has a beta of .2?

ANSWER (A)

If B (debt) =0.2, then the asset beta for each of Amalgamateds division is the following:

D/CAPITAL (%)

0.3

0.2

0.4

DIVISIONS

D's beta

E/CAPITAL (%)

0.2

0.7

0.2

0.8

0.2

0.6

E's beta

0.8

1.6

1.2

A's beta

0.62

1.32

0.8

ANSWER (B)

If B (debt) =0.2, debt is risk-free, risk-free rate = 7%, debt/capital is 0.29, and the above

DIVISION

S

D/CAPITAL

(%)

FOOD

ELECTRO

NICS

CHEMICA

LS

D's

beta

E/CAPITAL

(%)

DIVISIONS'

EQUITY BETA

AMALGAMATED'S EQUITY

BETA

0.3

0.2

0.7

0.62

0.31

0.2

0.2

0.8

1.32

0.396

0.4

0.2

0.6

0.8

0.16

0.866

mentioned (see A above) estimates of divisional betas are right, Amalgamateds equity beta =

Beta (asset) = D/(D+E)*Beta (debt) + E/(D+E)*Beta (equity) =>

0.28 = 0.29*0.2+0.71* Beta (equity) =>

Beta (equity) = (0.28-0.29*0.2)/0.71 = 0.31

ANSWER (C)

D/CAPITAL

(%)

0.3

0.2

0.4

Question6:

D's

beta

0.2

0.2

0.2

DIVISIONS

E/CAPITAL

E's

(%)

beta

0.7

0.8

0.8

1.6

0.6

1.2

A's

beta

0.62

1.32

0.8

COST OF

CAPITAL

12%

18%

13%

Pavlova&C, that high quality coffee maker, has a Beta on Equity of 1.1 and a Beta on Debt of

.15. Calculate the cost of capital if the capital structure is 50% debt. Tomorrow the capital

structure changes to 80% debt. Compute the new Beta on equity and Beta on Assets if the

Beta on debt remains constant as you do not expect a change in credit rating. What is the

WACC after the change of capital structure? What is the main lesson? Assume there are no

taxes. Assume the risk free rate is 7% and the risk premium is 5%.

Beta

(EQUITY)

Beta (DEBT)

D (%)

E (%)

Beta (ASSET)

COST OF

EQUITY

WACC

1.10

0.15

0.50

0.50

0.63

1.10

0.15

0.80

0.20

0.34

0.2%

4%

0.1%

6%

The more debt the Co has, the lower the cost of equity is. WACC is higher with more debt,

the Cos value is lower.

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