Background Page:

You may use the information on this page for any part of the exam. All values are current.

Company Business
Asset
Beta
Equity
Beta
Equity
Standard
Deviation Debt
Total
Firm
Value
Stock
Price
Next
Dividend
Per Share
This Years
Cash Flows
EJ H Construction 0.9 0.45 $40M $100M $1.00 $5M
KMS Design 1.5 0.50 $50M $500M $40.00 $1.50 $20M
CSH Construction 0.40 $2.13 $0.75 $4M


The cash flows in this table are cash flows available for stock holders.

Total firm value means equity plus debt.

Risk-free rate: 0.03
Market risk premium (E[R
m
] - r
f
) =0.07

Assume that the beta of debt is always zero.

The corporate tax rate is 35%.

Capital structure changes have no transaction costs and do not affect investment policy.

For each stock, the next dividend will be paid in exactly one year.
NAME______________________________
1 of 4
1. KMS has a higher standard deviation than CSH. What does this imply about CSHs
equity beta compared to KMS equity beta? Explain. [8]

Nothing. As we discussed in class, beta measures only systematic risk while standard
deviation measures total risk. Furthermore, beta and standard deviation are not
quoted in the same units, so you cannot directly compare them. It is quite possible
that even though KMS has a higher total risk (standard deviation) than CSH, less of
that total risk is due to systematic risk than it is for CSH, so CSH could have a
higher beta, meaning more systematic risk, but still have a lower standard deviation
(just by having a small amount of unsystematic risk).


2. What is a good estimate of the equity value of CSH? Explain your reasoning. [8]


CSH and EJH are both in the construction business, so your best bet is to use the
way the market values CSH to value EJH. The background page shows that EJH
has a total firm value of $100M and debt of $40M, meaning that its equity is $60M.
You also see that EJHs current cash flows for equity holders are $5M. Thus, EJH is
trading at 12 times cash flows ($60M/$5M = 12). Since CSH is also in the
construction business, it would be reasonable to assume that the market will value it
similarly, also pricing it at 12 times cash flows. CSHs cash flows are $4M, so its
equity value would be $48M.


3. If the stock market is efficient, that means the expected NPV of investing in the market is
zero. Does that mean you shouldnt invest? Explain. [8]

No. A zero NPV simply means that you are getting a fair return for the amount of
(systematic) risk you are taking-on. There is nothing wrong with getting the fair
return. In an efficient market, you should not expect to get an abnormally high
return for the amount of risk you are takingif such an opportunity were offered,
everyone would want to buy it, and the price would rise until the return was just
fair again. In the long run, simply earning the fair market return has compounded
to a substantial growth in the initial investment.

NAME______________________________
2 of 4
4. If a portfolio that is 30% KMS stock and 70% CSH stock has a portfolio beta of 1.29,
what is the expected return of CSH stock? [10]

We know that the beta of a portfolio is a weighted average of the betas of the stocks
in the portfolio. Also, the background sheet shows that KMS beta is 1.5. Thus,
1.29 (.30)(1.5) (.70) 1.2
P CSH CSH
| | | = = + = . Armed with that information, you can
use the CAPM to compute the expected return on CSH stock:
( ) [ ] .03 1.2 .07 .114
CSH
E R = + = .

5. If you have a portfolio that consists of $4,000 in KMS bonds and $36,000 in KMS equity,
what would be the expected return of your portfolio? [8]

The most common approach is: r
D
= .03+0(.07)=.03. r
E
= .03+1.5(.07)=.135
R
P
= (.10)(.03)+(.90)(.135)=.1245

Heres another way: The weights on your portfolio are 4000/(4000+36000) = .10 in debt and
36000/(4000+36000)=.90 in equity. These are also the weights of debt and equity in KMS capital
structure. KMS has a total value of $500M and is $50M debt, meaning that it has $450M equity.
Thus the weights of debt and equity in KMS capital structure are 10% and 90% as well. We know
that if we hold a portfolio of the debt and equity of a company in proportion to their weights in the
capital structure, our portfolio will have an expected return equal to the firms pre-tax WACC:
Assets equity debt
E D
WACC r r r
D E E D
= = +
+ +
. Also note that as we discussed in class, the pre-tax
WACC is the firms expected return on its assets as a whole, which can be computed from the CAPM
using its asset beta. Now, you just need KMS asset beta. KMS has an equity beta of 1.5 and has
$50M in debt and $450M in equity:
1.5(.90) 0(.10) 1.35
a e d
E D
D E D E
| | | = + = + =
+ +

Now, you are ready to get the expected return on your portfolio from the CAPM:
[ ] .03 1.35(.07) .1245
P
E R = + =

6. If EJ H has 2 million shares outstanding, what do you expect the price per share to be
immediately after the next dividend is paid (hint: start by figuring the current price)? [10]

In question 2, we figured out that EJH has a total equity value of $60M. If it has 2M
shares outstanding, then each share must have a price of $60M/2M = $30.
According to the background sheet, EJH pays a dividend of $1 per share. So, what
you have is
1
1
30 1
[ ]
30
t t t t
EJH
t
P P D P
E R
P

+ +
= = , but we need to know E[R
EJH
] to solve
this. We can find that from the CAPM is we know the equity beta of EJH. EJH has
an asset beta of 0.9, $40M in debt and $60M in equity:
40
0.9 0.9 1.5
60
e a a
D
E
| | |
| |
= + = + =
|
\ .
. With that, you can solve for the expected
return on EJH equity and then use that to compute next years expected price:
30 1
[ ] .03 1.5(.07) .135 $33.05
30
t
EJH t
P
E R P
+
= + = = =
NAME______________________________
3 of 4

7. EJ H is considering a capital structure change. It will issue $20 million in new debt with a
coupon rate of 5% and reduce its stock by $20 million. The debt will be permanent.

a. What will the new value of EJ H be? How much will be equity and how much will be
debt? [8]

Since the debt will be permanent, you can compute the PV of the interest tax
shield using a perpetuity: (.35)(20) 7
C D
ITS C
D
Dr
PV D
r
t
t = = = = , so the swap would
create a tax shield with a PV of $7 million. The new value of the firm will be:
V
New
= V
Old
+ Equity + Debt + PV
ITS
Transaction Costs
V
New
= 100 -20 + 20 + 7 0 (since the background sheet says there will be no trans. costs).
EJH started with $40M in debt and added $20M, so the new total debt will be $60M, leaving
$107-$60M = $47M as the residual for the equity holders.

b. By how much will its stockholders expected return increase? [8]

In question 6, we computed that EJH had an equity beta of 1.5 and an expected
return on equity of .135. The capital structure change will change the equity beta
(but not the asset beta), and hence the expected return on equity. The new
amount of debt is $60M and equity is $47M and the asset beta is still 0.9, so the
new equity beta is:
60
0.9 0.9 2.05
47
e a a
D
E
| | |
| |
= + = + =
|
\ .
and the new expected
return on equity is 0.03+2.05(.07)=.1735. Since the old expected return on equity
was .135, the increase is 0.0385 (3.85%).


8. If KMS and CSH stock have a correlation of 0.3, what is a 95% prediction interval for
next years return for a portfolio that is 50% KMS and 50% CSH? [8]

We need the expected return plus or minus 2 standard deviations:
( )( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
2 2 2 2 2
.5 .4 .5 .5 2 .5 .5 .4 .5 .3 0.1325
.1325 .364
P
P
o
o
= + + =
= =


To get the expected return, we need the portfolio beta, or the expected returns of
each stock. Earlier, we computed the expected return of CSH as 0.114 and of KMS
as 0.135.
E[R
P
]=(0.5)(0.114)+(0.5)(0.135)=.1245

So, the 95% confidence interval is .1245 2(.364) to .1245+2(.364), which is -0.6035
to +0.8525.

NAME______________________________
4 of 4
9. What is KMS after-tax WACC? [8]

We already have computed KMS r
E
to be 0.135 and its r
D
to be 0.03 (since its debt
beta is zero). Also, KMS is 90% equity and 10% debt: 450/500 is equity and 50/500
is debt. The tax rate is given as 35%

( ) % (1 ) % 0.135 0.90 0.03(1 0.35)(0.10) 0.123
WACC AfterTax E D C
r r E r T D

= + = + =


10. You have a company that has two divisions: design and construction. Your design
division has cash flows of $2 million and your construction division has cash flows of $3
million this year. What is your companys pre-tax WACC? [8]

Using the P/CF ratios from the information page, you can value each of the
divisions. KMS equity has a value of $450 million relative to $20 million in cash
flows, so its ratio is 450/20 = 22.5. EJH has a total equity value of $60 million
relative to cash flows of $5 million, so its ratio is 60/5 = 12. We can value our two
divisions:
Design: $2 million x 22.5 = $45 million.
Construction: $3 million x 12 = $36 million
Our companys pre-tax WACC is a weighted average of the pre-tax WACCs of the
two divisions, where the weights come from the divisional values. The pre-tax
WACC of the design division should be the same as KMS pre-tax WACC and for
construction should be the same as EJH or CSH, both of which are in construction.
We can use the formula from #9 without the tax adjustment to get the pre-tax
WACC for KMS: 0.9(.135)+0.1(0.03)=.1245
For EJH, we have the asset beta of 0.9, so we can use the CAMP: 0.03+.9(.07)=0.093
So your overall pre-tax WACC is:
45 36
0.1245 0.093 0.1105
36 45 36 45
pre tax A
WACC r

| | | |
= = + =
| |
+ +
\ . \ .


11. Your friend notices that Starbucks has a beta of 1.2 and asks you what that means. Write
your explanation of what a beta of 1.2 means. [8]

Beta is a measure of systematic risk. Using the market as a basis with a beta of 1,
this means that Starbucks has more than average systematic risk, such that ON
AVERAGE, when the markets excess return is 1% up or down, Starbucks excess
return is 1.2% in the same direction.