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Tutorial6

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.

Expected return's sensitivity to beta's change

-2%

0%

2%

4%

6%

8%

What is the risk premium on the market?

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%

If an investment with a beta of .8 offers an expected return of 7.7%, does it


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.

Answer: WACC = 12.4%.


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.

Since debt is risk-free (i.e. B (debt) = 0), B (asset) = B (equity) =E/(E+D)* B


(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 =

Amalgamateds beta (asset) = 0.29*0.2 + 0.71*(0.5*0.31+0.3*0.396+0.2*0.16) = 0.28


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.