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7211AFE Corporate Finance Practice Questions for Final Exam

Question 1 The risk-free rate of return is 4% and the market risk premium is
Question 1
The risk-free rate of return is 4% and the market risk premium is 8%. What is the expected
rate of return on a stock with a beta of 1.28?
Answer: 14.24%
CAPM R = Rf + b(Rm-Rf) = 4% + 1.28*8% = 14.24%
Question 2
Assume that Diamond Ltd’s last dividend was $2 per share and the dividend is expected to
grow at 7.5% indefinitely. The shares currently sell for $30. What is Diamond Ltd’s cost of
equity capital?
Answer: 14.7%
Question 3
Nuovo, Inc. stock has a beta of .86 and an expected return of 10.5 percent. The risk-free rate
of return is 3.2 percent and the market rate of return is 11.2 percent. Is this stock underpriced
or overpriced? Why? CAPM= 10,08, RRR=8,4%
Answer: Nuovo stock is underpriced.

Question 4

 

EBIT for Sharks Ltd is $163.934 and the cost of capital (Ru) is 20%. Taxes are 39%. What is

the value of the firm?

 

Answer: $500

 

Question 5

 

The expected return on HiLo stock is 13.69 % while the expected return on the market is

 

11.5%. The beta of HiLo is 1.3. What is the risk-free rate of return?

 

Answer:

4.2%

 
Question 6 Priscilla owns 500 shares of Delta stock. The company recently issued a statement
Question 6
Priscilla owns 500 shares of Delta stock. The company recently issued a statement that it will
pay a $1.00 per share dividend this year and a $.50 per share dividend next year. Priscilla does
not want any dividend this year but does want as much dividend income as possible next year.
Her required return on this stock is 12 percent. Ignoring taxes, what will Priscilla’s homemade
dividend per share be next year?
Answer: $1.62
Question 7
Calculate the expected return from the following information:
Event
Prob. Of event happening
Return
A
.25
.5
B
.50
.2
C
.20
.1
D
.05
-.2
Answer: 0.235

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Question 8

 

What is the market return if the expected return on asset A is 15% and the 10-year

 

government bond rate is 6%. Beta for asset A is .9.

 

Answer: 16%

 

Question 9

 

What is the portfolio variance if 30 percent is invested in stock S and 70 percent is invested in

stock T?

 
 

State of

Probability of State of Economy

Returns if State Occurs

Economy

Stock S

Stock T

Boom

 

40%

12%

20%

Normal

60%

6%

4%

Answer: 0.004056

 

We now have the payoffs in each state:

 

Use equation (28)

 

E(R P ) = pr(boom) ×payoff(boom) + pr(normal) ×payoff(normal)

 

= 0.4×0.176+0.6×0.046 = 0.098

 

Now use equation (29)

 

Var(R P ) = 0.4 × (0.176-0.098) 2 + 0.6 × (0.046-0.098) 2 = 0.004056

 
Question 10 Starfish limited has a WACC (unadjusted) of 12%. It can borrow at 8%.
Question 10
Starfish limited has a WACC (unadjusted) of 12%. It can borrow at 8%. Assuming that the
company has a target capital structure of 80% equity and 20% debt, what is its cost of equity?
Answer: 13%
Question 11
Merlo, Inc. maintains a debt-equity ratio of .40 and follows a residual dividend policy. The
company has after-tax earnings of $1,600 for the year and needs $1,400 for new investments.
What is the total amount Merlo will pay out in dividends this year?
Answer: $600
Question 12
You recently purchased a stock that is expected to earn 12 % in a booming economy, 8 % in a
normal economy and lose 5 % in a recessionary economy. There is a 15 % probability of a
boom, a 75 % chance of a normal economy, and a 10 % chance of a recession. What is your
expected rate of return on this stock?
Answer: 7.30 %
Question 13
Shares are currently selling for $4.4625. At the beginning of the year you bought them for
$4.25 and during the year a dividend of 21.25 cents per share was paid. What is the return?
Answer: 10%
Question 14
Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5
percent and the market risk premium is 8 percent?

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Stock Expected Return

Beta

 
 

A .68

8.2%

 

B 1.42

13.9%

C 1.23

11.8%

D 1.31

12.6%

 

E .94

9.7%

Answer:

B

 

The market risk premium is E(R m )-R f = 0.08, R f = 0.025

 

E(R A ) = R f + b (E(R m )-R f ) = 0.025 + 0.68×0.08 = 0.0794

E(R B ) = 0.1386 E(R C ) = 0.1234 E(R D ) = 0.1298 E(R E ) = 0.1002

 

Stock B is correctly priced (assuming the CAPM holds).

 

Question 15

 

Using the following information, calculate the portfolio beta and expected return:

   

Event Wealth invested

 

Expected return

 

Beta

   

A $1,000

   

8%

   

0.80

 

B $2,000

   

12%

   

0.95

 

C $3,000

   

15%

   

1.10

 

D $4,000

   

18%

   

1.40

 

Answer: 1.16, 14.9%

 
Question 16 Shoes’R’Us is an unlevered firm. Cost of capital for the firm is 10%.
Question 16
Shoes’R’Us is an unlevered firm. Cost of capital for the firm is 10%. The firm’s cash flows
are $700 every
year forever. What is the value of the firm?
Answer: $7000
Question 17
Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 % and the market rate of
return is 10 %. What is the amount of the risk premium on Zelo stock?
Answer: 6.77 %
Question 18
If the economy booms, RTF Inc. stock is expected to return 10 %. If the economy goes into a
recessionary period, then RTF is expected to only return 4 %. The probability of a boom is 60
% while the probability of a recession is 40 %. What is the variance and standard deviation of
the returns on RTF Inc. stock?
Answer: 0.000864, 2.9%

Question 19

 

The Lingo Co. has a debt-equity ratio of .60. The firm is analyzing a new project which

 

requires an initial cash outlay of $450,000 for new equipment. The flotation cost for new

equity is 10 percent

and for debt 5 percent. What is the true cost of the project?

 

Answer:

$489,796

 

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Question 20

 

You own 300 shares of Abco, Inc. stock. The company has stated that it plans on issuing a

 

dividend of $.60 a share at the end of this year and then issuing a final liquidating dividend of $2.20 a share at the end of next year. Your required rate of return is 9 percent. Ignoring taxes,

what is the value of one share of this stock today?

 

Answer: $2.40

 

Question 21 Astra limited company sells a slice of pizza for $1.20. The variable cost is 80 cents per slice and the marketing operation has fixed costs of $360 000 per year. Depreciation is $60 000 per year. What is the accounting break-even? Answer: 1 050 000 slices of pizza

Question 22

 

Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30.

The dividend growth rate is 4 %. The market has a 10 % rate of return and a risk premium of

 

6 %. What is the average expected cost of equity for Rosie’s Grill?

 

Answer:

10.10 %

 
Question 23 What are the arithmetic and geometric average returns for a stock with annual
Question 23
What are the arithmetic and geometric average returns for a stock with annual returns of
21 %, 8 %, -32 %, 41 %, and 5 %?
Answer: AM 8.6 %; GM 5.6 %
Question 24
Sparkle Inc has a debt-equity ratio of 1. Its weighted average cost of capital is 11%, and its
cost of debt is 9%. The corporate tax is 35%.
a) What is Sparkle’s cost of equity capital?
b) What is Sparkle’s unlevered cost of equity?
c) Sparkle is increasing its debt proportion in the firm (at the same cost) so that the debt-
equity ratio is 1.5? What is the cost of capital then?
Answers: a) 16.15%; b) 13.33%; c) 10.53%
Question 25
The Lakeside Inn is considering expanding their operations. Fixed costs are estimated at
$92,000 a year. The variable cost per unit is estimated at $22.50. The estimated sales price is
$37.50 per unit. What is the cash break-even point of this project? (Round to whole units)
Answer: 6,133
Question 26
Tom’s Ventures has a zero coupon bond issue outstanding that matures in thirteen years. The
bonds are selling at 48 % of par value. The company’s tax rate is 34 %. What is the
company’s after-tax cost of debt?
Answer: 3.83 %
Question 27

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Suppose that your firm has a cost of equity of 18% and a cost of
Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target D/E
is 0.60 and the tax rate is 35%, what is the firm’s WACC?
Answer: 13.2%
Question 28
A
stock had returns of 8 percent, -2 percent, 4 percent, and 16 percent over the past four
years. What is the standard deviation of this stock for the past four years?
Answer: 7.5%
Question 29
Your firm has earnings before interest and taxes of $160,000. Both the book and the market
value of debt is $300,000. Your unlevered cost of equity is 12% while your cost of debt is
8%. The tax rate is 35%. What is your weighted average cost of capital?
Answer: 10.7%
Question 30
A
company has preferred stock outstanding which pays a dividend of $6 per share a year. The
current stock price is $75 per share. What is the cost of preferred stock?
Answer: 8%

Question 31 You are considering a new project. The project has depreciation of $720, fixed costs of $6,000, and selling price per unit of $9.80. The variable cost per unit is $4.20. What is the accounting break-even level of production? Answer: 1,200 units

Question 32

 

Douglass Enterprises has a capital structure which is based on 40 percent debt, 10 percent

 

preferred stock, and 50 percent common stock. The after-tax cost of debt is 6 percent, the cost

of

preferred is 7 percent, and the cost of common stock is 9 percent. The company is

 

considering a project that is equally as risky as the overall firm. This project has initial costs

 

of

$125,000 and cash inflows of $76,000 a year for two years. What is the projected net

 

present value? Should this project be accepted or rejected?

 

Answer: $11,275.07, yes

 
Question 33 Katie’s Boutique has zero-coupon bonds outstanding that mature in four years. The bonds
Question 33
Katie’s Boutique has zero-coupon bonds outstanding that mature in four years. The bonds
have a face value of $1,000 and a current market price of $820. What is the company’s pre-
tax cost of debt?
Answer: 5.09 %
Question 34
Spartan Co. has earnings of 25 million per year every year. Currently the firm has no debt and
the cost of capital is 13%. If tax is 35% what is the value of the firm?
Answer: $125m
Earnings are $25m/year; no debt WACC = 0.13, t=0.35
V U = EBIT(1-t) / R U = (25m) (1-0.35) / 0.13 = $125m

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t=0.35 V U = EBIT(1-t) / R U = (25m) (1-0.35) / 0.13 = $125m 5

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Question 35 Spartan Co decides to undergo a capital restructuring by issuing bonds that have
Question 35
Spartan Co decides to undergo a capital restructuring by issuing bonds that have a market
value of 65 million at a cost of 9.5%. What is the weighted average cost of capital?
Answer: 11%
You issue bonds with a market value of $65m, value of leverage firm:
V L = V U + T C ×D = 125m + 0.35×65m = 147.75m
=> E = 147.75m – 65m = 82.75m;
w D =65/147.75 = 0.44; w E = 0.56
Hence D/E = 65.0/82.75 = 0.785
Recall (46): Cost of equity
R E = R A + (R A – R D ) ×(D/E) ×(1-t) = 0.13 + (0.13 – 0.095) (65/82.75) (0.65) = 0.1479
Recall (37):
WACC = w E R E + w D R D (1-t)
= 0.56 (0.14787) + 0.44 (0.095)(1-0.35) = 0.11

Question 36

After successful operating for a number of years, Spartan Co decides to increase even further

the leverage so that the debt-to-equity ratio becomes 1.2. What is the cost of capital?

Answer: 10.52%

R E = 0.13 + (0.13 0.095)(1.2)(0.65) = 0.1573

If D/E = 1.2, D=1.2 & E=1.0, => w D = 1.2/2.2, w E =1/2.2

WACC = w E R E + w D R (1-t)

= (1.0/2.2) (0.1573) + (1.2/2.2) (0.095) (0.65) = 0.10518

Question 37

 

Calculate the expected return of the portfolio:

Asset

 

Wealth invested

 

E(Ri)

 

A

200

 

15%

 

B

100

 

20%

 

C

500

 

10%

 

Answer: 12.5%

 

Question 38

 

ABC limited have 50 000 shares outstanding that sell in the market for $17.50 each. Share’s

beta coefficient is 1.2. The market risk premium is 8% and the risk-free rate is 5%. What is

ABC limited’s cost of equity capital and the market value of equity?

 

Answer: 14.6%, $875 000

 

Question 39

 

Uptown Interior design has the same market value as the book value of its balance sheet

 

accounts. The firm has declared a dividend of $0.35 per share that will be paid in two days

 

time. The company has 8,000 shares of stock outstanding trading in the market. The balance

sheet is presented in the following table:

 
 

Balance Sheet

 

Cash

 

25,000

 

Equity

 

190,000

Fixed Assets

165,000

     
 

Total

 

190,000

   

Total

190,000

a) Ignoring taxes, what is the stock selling for today?

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b) What will it sell in two days time after the ex dividend date? c)
b) What will it sell in two days time after the ex dividend date?
c) What are the accounts affected after the dividends are paid and what will be their new
balance?
Answers: a) $23.75; b) $23.40 c) Cash $22 200 and Equity $187 200
Question 40
Uptown Interiors has decided to consider an alternative to cash dividend. Instead of paying a
dividend, the firm will repurchase $5 200 worth of stock.
a) What effect will this transaction have on the equity of the firm?
b) How many shares were repurchased? (round your answer)
c) How many shares will be outstanding?
d) What is the new equity value?
e) What will the price per share be after the repurchase?
Answer: a) reduce; b) 219; c) 7 781; d) $184 800; e) same $23.75
a)
If you repurchase the stock, this is similar to a cash dividend;
your cash account falls by $5200 and so does your equity account.
b)
Since the price is 23.75 then you retire 219 shares
Shr repurchased =cash/P= $5200/23.75 = 219
c)
The number of shares outstanding falls from 8000 to 7781 (=8000-219).
d)
New equity value, E’ = E – cash = 190,000 – 5200 = 184,800
e) Since stock repurchases do not impact the value of the firm,
price/share remains unchanged at $23.75

Question 41

 

Shirley’s and Son have a debt-equity ratio of .60 and a tax rate of 35 %. The firm does not

 

issue preferred stock. The cost of equity is 10 % and the cost of debt is 8 %. What is Shirley’s

weighted average cost of capital?

 

Answer: 8.2 %

 

Question 42

 

You are an investor in BHP and own 100 shares. BHP shares sell for $41. The company is

 

about to pay a $1 dividend but you prefer a $3 dividend. What will you do to receive the

 

desired income of $300?

 

Answer: sell 5 shares ex dividend

 

Question 43

 

Today, you sold 200 shares of SLG Inc. stock. Your total return on these shares is 12.5

 

percent. You purchased the shares one year ago at a price of $28.50 a share. You have

received a total of $280 in dividends over the course of the year. What is your capital gains

yield on this investment?

 

Answer: 7.59 %

 

-1

0

 

28.5

P0+1.4

DPS = Div/shares = 280/200 = 1.4

 

ret = (DPS+ch_P)/P_1 => 12.5% = (1.4 + P0-28.5)/28.5 => P0=30.66

 

ch_P/P_1 = (P0-P_1)/P_1 = (30.6-28.5)/28.5 = 7.59%

 

Question 44

Question 44 Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8%
Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent

Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent semi-annual bonds outstanding, par value $100 each. The common stock currently sells for $25 per share, and has a beta of 1.25, and the bonds have 10 years to maturity and sell for

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93% of par. Cost of debt is 9.08%. The market risk premium is 10%, the
93% of par. Cost of debt is 9.08%. The market risk premium is 10%, the return on risk free
rate is 4.5%, and tax rate is 30%.
a) What is the firm’s market value of debt and equity?
b) Caterpillar is evaluating a new investment project that has the same risk as the overall firm,
what is the rate that the firm should use to discount the project’s cash flows?
Answer: a) 139.5m, 200m; b) 12.63%
MV of equity = #shares × price = 8m × 25 = $200m
MV of debt = 1.5m × $93 = $139.5
E(R m )-R f = 0.10; R f = 0.045; Beta= 1.25
CAPM: E(R) = 0.045 + 1.25(0.10) = 0.17
Cost of debt = YTM = 9.08%
WACC = (200/339.5)(0.17) + (139.5/339.5)(0.0908)(1-0.3) = 0.1263
Question 45
The fixed costs of a project are $8,000. The depreciation expense is $3,500 and the operating
cash flow is $20,000. What is the degree of operating leverage for this project?
Answer: 1.40

Question 46

 

Jack’s Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds

 

with similar characteristics are yielding 8.5 %. Face value of a bond is $1000. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells

for $40 a share. The U.S. Treasury bill is yielding 4 % and the market risk premium is 8 %.

Jack’s tax rate is 35 %. What is Jack’s weighted average cost of capital?

 

Answer: 10.38 %

 

Question 47 Stark company has decided to restructure its capital. Currently, it uses no debt financing. Following the restructuring, debt will be $1 million. The interest rate on the debt will be 9%. The company currently has 200 000 shares outstanding and the price per share is $20. If the restructuring is expected to increase EPS, what is the minimum level of EBIT that the firm’s management must be expecting? Answer: $360 000

Question 48

 

Strip Tavern has the cost of equity at 14% and the cost of debt at 6.5%. Assuming that the

   

target debt/equity ratio is 50% and the company tax rate is 34%, calculate the overall cost of

 

capital.

 

Answer: 10.7%

 

Question 48b

 

The Can-Do Co. is analysing a proposed project. The company expects to sell 12,000 units,

plus or minus 4 percent. The expected variable cost per unit is $7 and the expected fixed cost

is $36,000. The fixed and variable cost estimates are considered accurate within a plus or

minus 6 percent range. The depreciation expense is $30,000 per year, over the 5 year life of

the project, using the straight line. The tax rate is 34 percent. The sale price is estimated at

 
   

$14 a unit, plus or minus 5 percent. a) What is the earnings before interest and taxes under the base case scenario?

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b) What is the earnings before interest and taxes under a best case scenario?

c) What is the net income under the worst case scenario? d) What is the NPV under the base case scenario if required rate of return is 12%?

Answer: a) $18 000; b) $37,497.60; c) -$278.78; d) $968.03

Question 49

 

You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have

received total dividend income of $322. What is the dividend yield?

 

Answer: 4.4%

 

Question 50 Printing Equip Co. are considering a project that costs $180 000, has a 6 year life, and no salvage value. Assume that depreciation is straight line. The required return of Printing Equip is 10.5% on such projects. Sales are estimated at 28 000 units per year. Price per unit is $9, variable cost per unit is $3.20, and fixed costs are $35 000 per year. The tax rate is 35%.



What is the accounting break-even point?

 





Calculate the base case cash flow and NPV What is the degree of operating leverage?



 

Suppose that you think that the sales projection is accurate only to within 15%. Evaluate the sensitivity of NPV to changes in that projection by showing the NPV in the best and

worst case.

 



 

Suppose the projections given are all accurate to within 4% except for sales volume, which is only accurate to within 10%. What are the upper and lower bounds for these projections?

Answer:

a)

11,207 units; b) $93,310, $220,503; c) 1.375; d) $288 466, $152 541

e)

Apply 10% to sales and 4% to the rest of variables.

Question 51

 

The Auto Group has 1,200 bonds outstanding that are selling for $980 each. Face value is

 

$1000. The company also has 7,500 shares of preferred stock at a market price of $40 each.

The common stock is priced at $32 a share and there are 32,000 shares outstanding. What is

the weight of the preferred stock as it relates to the firm’s weighted average cost of capital?

Answer:

12%

 

Question 52

 

Telco Inc. has a beta of 1.3 and an expected return of 18%. Woollies Co. has a beta of 0.80

 

and an expected return of 9.5%. If Treasury Bills yield a return of 5% and the market return is

11.75%, which stock is under/overvalued relative to the other? Show why.

 

Answer: Telco is undervalued relative to Woollies.

 

Reward to risk ratio for each stock: [ E(r) R f ] /

Telco: ( 0.18 0.05 ) / 1.3 = 0.10

 

Woolies: ( 0.095 0.05 ) / 0.8 = 0.05625

 

=> Woolies is overvalued, Telco is undervalued

 

Examples of Short Questions in the exam:

What is the Portfolio Theory assumption?

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Investors prefer the portfolio with the highest expected return for a given variance, or, the lowest variance for a given expected return

Discuss the information effect or the signalling effect of dividends.

Dividends and Signals Asymmetric information managers have more info about the health of the company than investors Information Content Effect > Changes in dividends convey information > Cause market reaction

- Dividend increases: Management believes it can be sustained, Expectation of higher future dividends, increasing present value, Signal of a healthy, growing firm

- Dividend decreases: Management believes it can no longer sustain the current level of dividends,

Expectation of lower dividends indefinitely; decreasing PV, Signal of a firm that is having financial difficulties

Explain and graphically show, together with the associated formulas, the M&M proposition I and II with taxes. Optimal capital structure is almost 100% debt, each additional dollar of debt increases the CFA of firm

What are some examples of direct bankruptcy costs? Administrative and legal costs

According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return.

1. The risk-free rate, Rf

2. The market risk premium, E(RM)

3. The systematic risk of the asset relative to average, which we called its beta coefficient,

Rf

Explain the concept of ‘homemade dividend policy’.

Homemade Dividend Policy Investors will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy

Discuss and graphically show with the associated formulas the Capital Structure Theory when the firm has debt but not taxes. There is no optimal capital structure in this case, as the capital structure has no influence on the firms value, without taxes, the total value is unaffected by its capital structure

What are some real-world factors that may cause one dividend policy to be preferable to another? Different Tax rates, flotation costs, dividend restrictions, desire for current income, uncertainty resolution

What is diversification? What is the variable that plays the most important role in reducing the portfolio risk?

The Principle of Diversification:

states that spreading an investment across many assets will eliminate some but not all of the risk. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns Size of risk reduction depends on covariances between assets in the portfolio there is a minimum level of risk that cannot be diversified away and that is the systematic portion

Unsystematic risk is essentially eliminated by diversification, but systematic risk cannot be reduced by

a portfolio

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Define the three forms of market efficiency. What do we mean when we say the markets are efficient? Capital Market Efficiency

Efficient Capital Markets: A market in which security prices reflect available information → based on available information, there is no reason to believe that the current price is too low or too high. efficient markets hypothesis (EMH): The hypothesis that actual capital markets, such as the NYSE, are efficient.

It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns 3 forms:

- weak form efficiency:

- Prices reflect all past market information such as price and volume

- investors cannot earn abnormal returns by trading on market information

- Implies that technical analysis will not lead to abnormal returns

- Empirical evidence indicates that markets are generally wfe

- semistrong form efficiency:

- Prices reflect all publicly available information including trading information, annual reports, press releases, etc. - investors cannot earn abnormal returns by trading on public information → fundamental analysis will not lead to abnormal returns

- strong form efficiency:

- Prices reflect all information, including public and private

- investors could not earn abnormal returns regardless of the information they possessed

- Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

What are the lessons learned from capital market history? Lessons from Capital Market History

- Data reflects two features often observed in financial markets: - There is a reward for bearing risk. - The larger the potential reward, the larger the risk.

- This is called the risk-return trade-off

- There is a positive relationship between risk and return

Explain the meaning of the dividend clientele effect and why it is important.

Clientele Effect Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts → If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter, it just changes its structure of investors

What are the components of total risk? Give examples of each.

Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small → almost = to the systematic risk

Systematic or unsystematic Risk

Systematic or Non-Diversifiable Risk, market risk: That portion of an asset’s risk attributed to the market factors that affect all firms and cannot be eliminated through the process of diversification. Unsystematic or Diversifiable Risk asset-specific risk: That portion of an asset’s risk which is firm specific and can be eliminated through the process of diversification

What is CAPM? In equilibrium, what does CAPM implies?

Shows the relationship between systematic risk and expected return Positive slope The higher the risk, the higher the return According to the CAPM, all stocks must lie on the SML, otherwise they would be under or overpriced. In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to risk ratio for the market, If not, assets are undervalued or overvalued

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What are other approaches of estimating the cost of capital of a project when the project is not of the same risk as the overall risk of the firm?

Other approaches to estimating a discount rate:

- divisional cost of capitalused if a company has more than one division with different levels of risk;

- pure play approach a discount rate that is unique to a particular project is used; Look at companies in the same line of business as the new project Calculate an average WACC for all the companies and use this rate as the discount rate of the new project

- subjective approach projects are allocated to specific risk classes which, in turn, have specified discount rates Consider the project’s risk relative to the firm overall risk If the project risk > firm risk, use a discount rate > WACC If the project risk < firm risk, use a discount rate < WACC

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