Week 2 Tutorial Questions and Solutions

12-1. Suppose Pepsico’s stock has a beta of 0.57. If the risk-free rate is 3% and the expected return of
the market portfolio is 8%, what is Pepsico’s equity cost of capital?
3% + 0.57  (8% – 3%) = 5.85%

12-2. Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while
Microsoft’s stock has a volatility of 30%.
a. Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is
higher than 10%?
b. What would have to be true for Microsoft’s equity cost of capital to be equal to 10%?
a. No, volatility includes diversifiable risk, so it cannot be used to assess the equity cost of capital.
b. Microsoft stock would need to have a beta of 1.

12-3. Aluminum maker Alcoa has a beta of about 2.0, whereas Hormel Foods has a beta of 0.45. If the
expected excess return of the marker portfolio is 5%, which of these firms has a higher equity cost
of capital, and how much higher is it?
Alcoa is 5%  (2 – 0.45) = 7.75% higher.

12-9. From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean the
market risk premium we should have used in the CAPM was negative?
No! Investors were not expecting a negative return. To estimate an expected return, we need much more
data.

12-10. You need to estimate the equity cost of capital for XYZ Corp. You have the following data available
regarding past returns:

a. What was XYZ’s average historical return?

b. Compute the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.
c. Estimate XYZ’s historical alpha.
d. Suppose the current risk-free rate is 3%, and you expect the market’s return to be 8%. Use
the CAPM to estimate an expected return for XYZ Corp.’s stock.
e. Would you base your estimate of XYZ’s equity cost of capital on your answer in part (a) or in
part (d)? How does your answer to part (c) affect your estimate? Explain.
a. (10% – 45%)/2 = –17.5%
b. Excess returns:
 MKT 3%, –38%
XYZ 7%, –46%
Beta = (7 – (–46))/(3 – (–38)) = 1.29
c. Alpha = intercept =
E[Rs – rf] – beta  (E[Rm – rf]) =
(7% – 46%)/2 – 1.29  (3% – 38%)/2 = 3.1%
d. E[R] = 3% + 1.29  (8% – 3%) = 9.45%
e. Use (d)—CAPM is more reliable than average past returns, which would imply a negative cost of
capital in this case!
Ignore (c), as alpha is not persistent.

12-14. In mid-2012, Ralston Purina had AA-rated, 10-year bonds outstanding with a yield to maturity of
2.05%.
a. What is the highest expected return these bonds could have?
b. At the time, similar maturity Treasuries have a yield of 1.5%. Could these bonds actually have
an expected return equal to your answer in part (a)?
c. If you believe Ralston Purina’s bonds have 1% chance of default per year, and that expected
loss rate in the event of default is 40%, what is your estimate of the expected return for these
bonds?
a. Risk-free => y = 2.05%
b. no
c. y – d  l = 2.05% – 1%(.40) = 1.65%

12-18. Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an all-
equity firm that specializes in this business. Suppose Harburtin’s equity beta is 0.85, the risk-free
rate is 4%, and the market risk premium is 5%. If your firm’s project is all equity financed,
estimate its cost of capital.
Project beta = 0.85 (using all equity comp)
Thus, rp = 4% + 0.85(5%) = 8.25%

12-19. Consider the setting of Problem 18. You decided to look for other comparables to reduce estimation
error in your cost of capital estimate. You find a second firm, Thurbinar Design, which is also
engaged in a similar line of business. Thurbinar has a stock price of $20 per share, with 15 million
shares outstanding. It also has $100 million in outstanding debt, with a yield on the debt of 4.5%.
Thurbinar’s equity beta is 1.00.
a. Assume Thurbinar’s debt has a beta of zero. Estimate Thurbinar’s unlevered beta. Use the
unlevered beta and the CAPM to estimate Thurbinar’s unlevered cost of capital.
b. Estimate Thurbinar’s equity cost of capital using the CAPM. Then assume its debt cost of
capital equals its yield, and using these results, estimate Thurbinar’s unlevered cost of capital.
c. Explain the difference between your estimate in part (a) and part (b).
 a. E = 20  15 = 300
E + D = 400
Bu = 300/400  1.00 + 100/400  0 = 0.75
Ru = 4% + 0.75(5%) = 7.75%
b. Re = 4% + 1.0  5% = 9%
Ru = 300/400  9% + 100/400  4.5% = 7.875%
c. In the first case, we assumed the debt had a beta of zero, so rd = rf = 4%
In the second case, we assumed rd = ytm = 4.5%

12-21. In mid-2015, Cisco Systems had a market capitalization of $130 billion. It had A-rated debt of $25
billion as well as cash and short-term investments of $60 billion, and its estimated equity beta at
the time was 1.11.
a. What is Cisco’s enterprise value?
b. Assuming Cisco’s debt has a beta of zero, estimate the beta of Cisco’s underlying business
enterprise.
a. EV = E + D – C = 130 + 25 – 60 = $95 billion
b. Net Debt = 25 – 60 = –35
Ru = (130/95)  1.11 + (–35/95)  0 = 1.52

12-23. Weston Enterprises is an all-equity firm with three divisions. The soft drink division has an asset
beta of 0.60, expects to generate free cash flow of $50 million this year, and anticipates a 3%
perpetual growth rate. The industrial chemicals division has an asset beta of 1.20, expects to
generate free cash flow of $70 million this year, and anticipates a 2% perpetual growth rate.
Suppose the risk-free rate is 4% and the market risk premium is 5%.
a. Estimate the value of each division.
b. Estimate Weston’s current equity beta and cost of capital. Is this cost of capital useful for
valuing Weston’s projects? How is Weston’s equity beta likely to change over time?
a. Soft drink
Ru = 4% + 0.6  5% = 7%
V = 50/(7% – 3%) = 1,250
Chemical
Ru = 4% + 1.20  5% = 10%
V = 70/(10% – 2%) = 875
Total = 1250 + 875 = $2.125 billion
b. Weston Beta (portfolio)
1250/2125  0.6 + 875/2125  1.2 = 0.85
Re = 4% + 0.85  5% = 8.25%
Not useful! Individual divisions are either less risky or more risky. Over time, Weston’s equity beta
will decline towards 0.6 as the soft drink division has a higher growth rate, and so will represent a
larger fraction of the firm.