Risk

•Systematic
•Unsystematic
 Expected Return

State of economy Probability of state of Rate of return if state

economy occurs
Stock L Stock U

Recession .5 -.20 .30

Boom .5 .70 .10

 Risk premium

The risk premium as the difference

between the return on a risky
investment and that on a risk-free
investment.
Suppose risk free investments are
currently offering 8 percent using
the above, what is the projected
risk premium on Stock U? On
Stock L?
Suppose you think a boom will
occur only 20 percent of the time
instead of 50 percent. What are
the expected returns on Stocks U
and Stocks L in this case? If the
risk-free rate is 10 percent, what
are the risk premiums?
Assuming an investor wanted to
compute the beta of Apple Inc. in
comparison to Facebook. Based
on recent five-year data, Apple
Inc. and Facebook have a
covariance of 0.032, and the
variance of Facebook is 0.015.
 SML/CAPM expected return

Suppose there are two investment

with an expected return of 16 % and
has the following details: the beta for
Asset A is 1.6 while Asset B has 1.2.
Both has a risk-free rate of 8%. Which
investment is better, Asset A or Asset
B?
Suppose the market risk premium is
about 7 percent. U.S. Treasury bills
are paying about .10 percent. ABC
Ltd. had an estimated beta of 1.85.
what is the cost of equity if the above
were true?
Suppose stock in Algo Ltd. has a beta
of 1.2. The market risk premium is 7
percent, and the risk-free rate is 6
percent. Algo’s last dividend was $2
per share, and the dividend is
expected to grow at 8 percent
indefinitely. The stock currently sells
for $30. What is Algo’s cost of equity
capital?
 Estimating g
Year Dividend

2010 1.10

2011 1.20

2012 1.35

2013 1.4

2014 1.55
 The cost of debt

Suppose the General Tool Company

issued a 30-year, 7 percent bond 8
years ago. The bond is currently
selling for 96 percent of its face value,
or $960. What is General Tool’s cost
of debt?
Weighted Average Cost of Capital

If the total market value of a

company’s stock were calculated as
$200 million and the total market
value of the company’s debt were
calculated as $50 million, what will be
the capital structure weights?
 Taxes

Suppose a firm borrows $ 1million at

a percent interest. The corporate tax
rate is 34 percent. What is the after
tax interest rate on this loan?
The Lean Co. has 1.4 million shares of stock
outstanding. The stock currently sells for $20
per share. The firm’s debt is publicly traded
and was recently quoted at 93 percent of face
value. It has a total face value of $5 million,
and it is currently priced to yield 11 percent.
The risk-free rate is 8 percent, and the market
risk premium is 7 percent. You’ve estimated
that Lean has a beta of .74. If the corporate
tax rate is 34 percent, what is the WACC of
Lean Co.?