FINM7402 Tutorial 2: Cost of Capital
QUESTION 1
In the big picture of corporate finance, the first big piece is the investment decision. Which of the following best characterizes that decision?
a. Firms should take investments that make them more profitable
b. Firms should take investments that generate the most cash flows
c. Firms should take investments that earn the highest returns
d. Firms should take investments that earn returns greater than the risk free rate
e. Firms should take investments that earn returns greater than the risk adjusted hurdle rate
QUESTION 2
In the big picture of corporate finance, the dividend principle states that firms should return as much cash as they can to their owners. If firms followed this principle, which of the following would you expect to observe?
a. Firms will pay out all of their earnings as dividends/stock buybacks
b. Firms will not pay out any of their earnings to stockholders
c. Firms that have high earnings and low growth potential will return more cash to stockholders.
d. Firms that have high earnings and high growth potential will return more cash to stockholders.
e. None of the above
Questions 3 – 9 from textbook Chapter 12 of Berk & DeMarzo: 2; 10; 15; 17; 20; 23; 26
QUESTION 3 (textbook Chapter 12 Q2).
Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft’s stock has a volatility of 30%.
a. Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is higher than 10%?
b. What would have to be true for Microsoft’s equity cost of capital to be equal to 10%?
QUESTION 4 (textbook Chapter 12 Q10).
You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns:
a. What was XYZ’s average historical return?
b. Compute the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.
c. Suppose the current risk-free rate is 3%, and you expect the market’s return to be 8%. Use the CAPM to estimate an expected return for XYZ Corp.’s stock.
d. Would you base your estimate of XYZ’s equity cost of capital on your answer in part (a) or in part (c)? Explain.
QUESTION 5 (textbook Chapter 12 Q15).
In mid-2009, Rite Aid had CCC-rated, 6-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 2%. Suppose the market risk premium is 4% and you believe Rite Aid’s bonds have a beta of 0.39. If the expected loss rate of these bonds in the event of default is 52%.
a. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009?
b. In mid-2015, Rite-Aid’s bonds had a yield of 8.8%, while similar maturity Treasuries had a yield of 0.8%. What probability of default would you estimate now?
QUESTION 6 (textbook Chapter 12 Q17).
The Dunley Corp. plans to issue 5-year bonds. It believes the bonds will have a BBB rating. Suppose AAA bonds with the same maturity have a 4% yield. Assume the market risk premium is 5% and use the data in Table 12.2 and Table 12.3.
a. Estimate the yield Dunley will have to pay, assuming an expected 50% loss rate in the event of default during average economic times. What spread over AAA bonds will it have to pay?
b. Estimate the yield Dunley would have to pay if it were a recession, assuming the expected loss rate is 71% at that time, but the beta of debt and market risk premium are the same as in average economic times. What is Dunley’s spread over AAA now?
c. In fact, one might expect risk premia and betas to increase in recessions. Redo part (b) assuming that the market risk premium and the beta of debt both increase by 20%; that is, they equal 1.2 times their value in recessions.
QUESTION 7 (textbook Chapter 12 Q20).
IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business:
What is your estimate of the project’s beta? What assumptions do you need to make?
QUESTION 8 (textbook Chapter 12 Q23).
Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.53, expects to generate free cash flow of $76 million this year, and anticipates a 4% perpetual growth rate. The industrial chemicals division has an asset beta of 1.14, expects to generate free cash flow of $44 million this year, and anticipates a 2% perpetual growth rate. Suppose the risk-free rate is 2% and the market risk premium is 4%.
a. Estimate the value of each division.
b. Estimate Weston’s current equity beta and cost of capital. Is this cost of capital useful for valuing Weston’s projects? How is Weston’s equity beta likely to change over time?
QUESTION 9 (textbook Chapter 12 Q26).
Unida Systems has 42 million shares outstanding trading for $10 per share. In addition, Unida has $94 million in outstanding debt. Suppose Unida’s equity cost of capital is 16%, its debt cost of capital is 8%, and the corporate tax rate is 35%.
a. What is Unida’s unlevered cost of capital?
b. What is Unida’s after-tax debt cost of capital?
c. What is Unida’s weighted average cost of capital?