FM-II-Classroom Exercise- “Hurdle Rates for Long- Run

Investment Analysis”
(XL-BM-2019 batch)
1. The Kshitij Diksha Vatsalya Kushagra Dhairya Nitesh Limited, a US based firm is
considering expanding into South America. The following information is available:
• The beta for the Limited is 1.40.
• The treasury bond rate is 7%, and the project analysis will be done in dollars.
• The risk premium for South American countries is expected to be 7.5%.
• Brady bonds issued by South American countries trade at a premium of 2% over the
treasury bond rate.
a. Estimate the cost of equity to use in evaluating the new South American stores.
b. Explain your reasoning and the conditions under which you might have decided
differently.

2. You are advising Anuja Anusha Apurva Anushree (AAAA Ltd) a phone company that
is planning to invest in projects in multimedia. The beta for the telephone company is 0.75
and has a debt/equity ratio of 1.00; the after-tax cost of borrowing is 4.25%. The multimedia
business is considered to be much riskier than the phone business; the average beta for
comparable firms is 1.30, and the average debt/equity ratio is 50%. Assuming that the tax
rate is 40%: (The riskless rate is 7%.)
a. Estimate the unlevered beta of being in the multimedia business.
b. Estimate the beta and cost of equity if the phone company finances its multimedia
projects with the same debt/equity ratio as the rest of its business.
c. Assume that a multimedia division is created to develop these projects, with a
debt/equity ratio of 40%. Estimate the beta and cost of equity for the projects with this
arrangement.

3. Intel(Ishaan Nikhil Trivedi Eshan Lalit) is exploring a joint venture with Ford (Furqan
Raghav Devagya) to develop computer chips to use in automobiles. Although Intel has
traditionally used a cost of equity based on its beta of 1.50 and a cost of capital based on
its debt ratio of 5%, it is examining whether it should use a different approach for this
project. It has collected the following information.
-The average beta for automobile component firms is 0.90, and the average debt/equity
ratio across these firms is 40%.
-The joint venture will be financed 70% with equity from Ford and Intel, and 30% with
new debt raised at a market interest rate of 7.5%.
• Estimate the beta that Intel should use for this project.
• Estimate the cost of capital that Intel should use for this project.
• What would be the consequences of Intel using its current cost of equity and capital on
this project?
4. Ramapriyan Rohan Raj Ltd (RRRL), the US based chocolate manufacturer, is
considering expanding its operations into Malaysia. Analysts are trying to estimate the
appropriate cost of capital to use in evaluating this expansion option and have collected the
following information.
• The beta for RRRL stock is 0.95.
• RRRL has traditionally used only a small amount of debt; its current debt ratio is 12%.
It is planning to raise this debt ratio to 20%. (The pre-tax cost of debt is 8%.)
• Institutional investors hold 65% of the outstanding stock at RRRL.
a. Estimate the cost of capital, in U.S. dollars, for this project, if the treasury bond
rate is 7.5%.
b. Did you charge a premium for currency risk? Why or why not?
c. Did you charge a premium for political risk? Why or why not?
d. Would your analysis have been any different if RRRL was privately held?

5. The Kriti Nikita Kashish Silpa Malika Shagun Ltd (KNKSMSL), a leading US based
clothing retailer is proposing to introduce a line of cosmetics. It has no debt and a beta of
1.45. However, the cosmetics firms have an average beta of 1.75 and an average debt/equity
ratio of 10%. The treasury bond rate is 7%, and the corporate tax rate is 40%. Also assume
that you have the following estimates of the cash flows on the project:
Year After-tax Cash Flows (to Equity)
0 -$10,000,000
1 + 3,500,000
2 + 4,000,000
3 + 4,500,000
4 5,000,000
5 5,000,000
The project ends after five years, and there is no salvage value.
a. Estimate the certainty equivalent factors each year for the next five years.
b. Convert the risky cash flows shown above into riskless cash flows, using the
certainty equivalent factors.

6. You are helping the financial managers of Phanindra Anhishek Sugandh Soham Pranav
Krishan a grocery store estimate a cost of capital to use in assessing new stores. The
grocery store, which is publicly traded, has a beta of 1.40 and a debt/equity ratio of 70%;
the after-tax cost of debt is 5.5%. The managers are trying to estimate costs of capital at
two different stores. One is a suburban store with little competition for which the cash flows
can be estimated fairly accurately. The other is a store in New York City, where the
estimates have much more potential for error. (The riskfree rate is 7%)
a. What cost of capital would you charge for these two stores?
b. Would you charge a higher cost of capital for the New York City store? Why or why
not?
7. Compaq is trying to estimate a cost of capital to use in assessing its entry into the high-end
workstation market. The publicly traded firms in this market have an average beta of 1.20
and an average debt/equity ratio of 20%. There is intense competition within the industry
for business. Compaq itself has a beta of 1.45 and carries a debt to equity ratio of only 10%
with an after-tax cost of debt of 5.5%. It plans to maintain this debt ratio on its new venture.
(The riskfree rate is 7% and the tax rate is 35%.)
a. Estimate the cost of capital for this new venture.
b. Would you charge a premium for the fact that this is an intensively competitive
industry? Why or why not?

8. Philip Morris is reexamining the costs of equity and capital it uses to decide on investments
in its two primary businesses — food and tobacco. It has collected the following
information on each business.
• The average beta of publicly traded firms in the tobacco business is 1.10, and the
average debt/equity ratio of such firms is 20%.
• The average beta of publicly traded firms in the food business is 0.80, and the average
debt/equity ratio of such firms is 40%.
Philip Morris has a beta of 0.95 and a debt ratio of 25%; the pre-tax cost of debt is 8%.
The treasury bond rate is 7%, and the corporate tax rate is 40%.
a. Estimate the cost of capital for the tobacco business.
b. Estimate the cost of capital for the food business.
c. Estimate the cost of capital for Philip Morris, as a firm.

9. Nowassume that Philip Morris in Problem 8 is considering separating into two companies
— one holding the tobacco business and the other the food business.
a. Assuming that the debt is allocated to both companies in proportion to the market
values of the divisions, estimate the cost of capital for each of the companies. Will it
be the same as the costs of capital calculated for the divisions? Why or why not?
b. Assuming that the tobacco firm is assigned all the debt and that both firms are of equal
market value, estimate the cost of capital for each company. (Assume that the pre-tax
cost of debt will increase to 10%, if this allocation is made.)

10. You are helping First Global, an international bank, decide on the costs of equity it should
be using to evaluate its various divisions. Currently, it has three divisions — commercial
banking, real estate, and investment banking. The betas of comparable firms in each
division are as follows. (Riskfree rate = 7%.)
Division Comparable Firms’ Beta
Commercial Banking 1.05
Real Estate 0.70
Investment Banking 1.40
a. Estimate the costs of equity for each division.
b. What would happen if you used First Global’s beta of 0.95 to estimate the cost of
equity for all three divisions?