Bridge program, Summer 2005

Finance module, Solutions to assignment 7

Solutions to assignment 7: Firm risk versus equity risk

1. What are the standard deviations of the stock returns of each of the rms? What are the betas of each of the rms? Simply apply =STDEV formula in Excel to get standard deviations. For the betas, from the hint we can use the function =CORREL, and then use the standard deviation information to back out the betas. The table below presents the results for the 5 assets. Recall the standard deviation of annual returns can be computed as 250 times the standard deviation of daily returns. S&P500 0.01 0.21 1 1 GOSHA 0.03 0.49 0.21 0.48 TOM 0.04 0.58 0.33 0.90 RL 0.03 0.45 0.35 0.74 BNG 0.02 0.34 0.20 0.33 LIZ 0.02 0.35 0.48 0.78

SD (daily) SD (annual) Correlation with the market Beta of equity

2. You further learn that GOSHA and BNG are all equity nanced. TOM has a capital structure with debt with market value of $500m, and equity currently valued at $2b. RL has debt with market value of $300m, and equity currently valued at $2b. LIZ has debt with market value of $400m, and equity currently valued at $3b. Rank the rms in terms of the risk of their underlying cash ows. The purpose of this question is to note that leverage adds to the risk of equity, even when the risk of the underlying cash ows is held constant (the celebrated Modigliani and Miller propositions). In particular, if we assume that D = 0, then we can back out the beta of the underlying assets by E 1 A = E = E ; E+D 1 + D/E where A is the asset beta, E is the equity (stock) beta, E is the market value of equity, and D is the market value of debt. See assign7sol.xls for details. 3. If you had to pick a discount rate for a project in the apparel industry, what discount rate would you suggest according to the data provided in this assignment? We can take a simple average of the ve rms to get an estimate for A in the apparel industry, which was about 0.58. Say using a medium-term risk-free rate of 5% seems reasonable (approximately 10-20 year spot rate) and a 5% market risk-premium, the CAPM formula yields r = 5 + 0.58(5) = 7.87% as a reasonable discount rate for projects in this industry. Warning: the estimates of the risk of the apparel industry are on the low side. It is not clear all apparel projects ought to have lower than average risk - I would even argue some higher-end products would have high(er) betas.

Tuck School of Business at Dartmouth

Pr. Diego Garc a