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# CHAPTER 10 Exercise 9: The total market value of the common stock of the Okefenokee Real Estate Company is \$6 million,

and the total value of its debt is \$4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 6 percent. The Treasury bill rate is 4 percent. Assume for simplicity that Okefenokee debt is risk-free and the company does not pay tax. Problem setting: (a) Stock value = \$6 million (b) Debt value = \$4 million (c) Company value=D+E= \$10 million (d) =1.5 (e) MRP=6% (f) Risk-free rate= 4% a. What is the required return on Okefenokee stock? requity = rf + (rm rf) = 0.04 + (1.5 0.06) = 0.13 = 13% b. Estimate the company cost of capital.

rassets =

## D E \$6million \$4million 0.13 rdebt + requity = 0.04 + V V \$10million \$10million

rassets = 0.094 = 9.4% c. What is the discount rate for an expansion of the companys present business? The cost of capital depends on the risk of the project being evaluated. If the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital. Here, the appropriate discount rate is 9.4%. d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okefenokees new venture. requity = rf + (rm rf) = 0.04 + (1.2 0.06) = 0.112 = 11.2%

rassets =

## rassets = 0.0832 = 8.32%

Exercise 10: Nero Violins has the following capital structure: Security Debt Preferred stock Common stock Beta 0 0.20 1.20 Total Market Value (\$ Millions) \$100 \$40 \$299

Problem setting: (a) Debt value= \$100 million (b) Preferred Stock value = \$40 million (c) Common Stock value = \$299 million (d) Company value=D+PE+CE= \$439 million a. What is the firms asset beta? Hint: What is the beta of a portfolio of all the firms securities?

C P D assets = debt + preferred + common = V V V \$299million \$40million \$100million 0 + 0.20 1.20 = 0.836 \$439million \$439million \$439million

b. Assume that the CAPM is correct. What discount rate should Nero set for investments that expand the scale of its operations without changing its asset beta? Assume a riskfree interest rate of 5 percent and a market risk premium of 6 percent. r = rf + (rm rf) = 0.05 + (0.836 0.06) = 0.10016 = 10.016%
Exercise 13: see Lecture slides

Exercise 15: You are given the following information for Fleece Financial Corp. Long-term debt outstanding Current yield to maturity (rdebt) \$300,000 8%

Number of shares of common stock Price per share Book Value per share Expected return on stock (requity) Calculate Fleeces company cost of capital. Ignore taxes.

## 10,000 \$50 \$25 15%

Problem setting: a) Market value of outstanding debt= \$300,000 b) Cost of debt capital= 8% c) Common stock market value is= \$50 10,000 = \$500,000 d) Cost of equity capital= 15% e) Company value= \$800,000

## Thus, Fleeces weighted-average cost of capital is:

300,000 500,000 rassets = 300,000 + 500,000 0.08 + 300,000 + 500,000 0.15

## rassets = 0.12375 = 12.4%

Exercise 16: Look again at Table 10.1. This time we will concentrate in Burlington Northern. Table 9.1 Reference Burlington Northern & Santa Fe Industry portfolio equity 0.83 0.87 Standard Error 0.19 0.16

a. Calculate Burlingtons cost of equity from the CAPM using its own beta estimate and

the industry beta estimate. How different are your answers? Assume a risk-free rate of 5% and a market risk premium of 7%. rBN = rf + BN (rm rf) = 0.05 + (0.83 0.07) = 0.1081 = 10.81%

## rIND = rf + IND (rm rf) = 0.05 + (0.87 0.07) = 0.1109 = 11.09%

b. Can you be confident that Burlingtons true beta is not the industry average? No, we cannot be confident that Burlingtons true beta is not the industry average. The difference between BN and IND (0.04) is less than one standard error (0.19), so we cannot reject the hypothesis that BN = IND. c. Under what circumstances might you advice Burlington to calculate its cost of equity based on its own beta estimate? Burlingtons beta might be different from the industry beta for a variety of reasons. For example, Burlingtons business might be more cyclical than is the case for the typical firm in the industry. Or Burlington might have more fixed operating costs, so that operating leverage is higher. Another possibility is that Burlington has more debt than is typical for the industry so that it has higher financial leverage.

Exercise 19: An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20 percent of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40 percent of new wells that strike oil produce only 1,000 barrels a day; 60 percent produce 5,000 barrels per day. a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of \$15 per barrel. Expected daily production = (0.2 0) + 0.8 [(0.4 x 1,000) + (0.6 x 5,000)] = 2,720 barrels. Expected annual cash revenues = 2,720 x 365 x \$15 = \$14,892,000 b. A geologist proposes to discount the cash flows of the new wells at 30 percent to offset the risk of dry holes. The oil companys cost of capital is 10 percent. Does this proposal make sense? Briefly explain why or why not.

The possibility of a dry hole is a diversifiable risk and should not affect the discount rate. This possibility should affect forecasted cash flows, however. See Part (a).

Exercise 21: see Lecture slides Exercise 22: The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-marketed for two years in southern California at an initial cost of \$500,000. This test launch is not expected to produce any profits but should reveal consumer preferences. There is a 60 percent chance that demand will be satisfactory. In this case McGregor will spend \$5 million to launch the scotch nationwide and will receive an expected annual profit of \$700,000 in perpetuity. If demand is not satisfactory, diet scotch will be withdrawn. Once consumer preferences are known, the product will be subject to an average degree of risk, and, therefore, McGregor will require a return of 12 percent on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 40 percent on this initial expenditure. What is the NPV of the diet scotch project? At t = 2, there are two possible values for the projects NPV: (a) With 40% of probabilities (so that demand is not satisfactory), the NPV of the project will be:
NPV2 ( if test is not successful) = 0

(b) With 60% of probabilities (so that demand is satisfactory), the NPV of the project will be:

## NPV2 ( if test is successful) = 5,000,000 +

Therefore, at t = 0:

NPV0 = 500,000 +