Solutions to Cost of Capital Problem Set 1. False: As stated, this higher risk is diversifiable.

The market, on average, does not reward an investor for carrying diversifiable/unsystematic risk so it will not yield higher expected returns. 2. CAPM: E(Ri) = Rf + i[E(RM) - Rf] which is to say that the expected return on any asset can be calculated as the risk-free rate plus the investments beta times the market risk premium (the expected return on the market minus the risk-free rate). For the example above, E(Ri) = .07 + 1.3(.14) = .252 You have estimated the stock to yield a 22 percent return, which is less than the 25.2 percent return calculated using the CAPM. Since you believe the CAPM holds, the stock is currently overvalued or priced too high (i.e., the estimated return, 22%, is too low). You should sell the stock now because it is overvalued. 3. False: Your portfolio currently contains assets that provide income streams positively related to changes in interest rates. To smooth your income stream, you need to also include assets with income streams that are negatively correlated with changes in interest rates. That is, as interest rates go down (up), your income from the negatively correlated assets will go up (down). 4. a. Find the number of bonds outstanding: Each bond has a $1,000 face value so you can find the number of bonds outstanding by dividing the total face value of the debt by $1,000. Therefore, there are 6,000 bonds outstanding ($6,000,000 / 1,000).
Bond Value = PV (Coupon Payments) + PV (Face Value) = $1,106.70

Market value of firms debt outstanding = bond value * number of bonds outstanding. Market value of firms debt outstanding = $1,106.70 * 6000 = $ 6,640,200 b. Required return = Rf + B* (Rm-Rf) The return on the market minus the risk-free rate is called the market risk premium, which is the data you are given. Required return = 0.08 + 1.20 * 0.09 = 0.188 To find the price per share of the firms common stock, use the constant growth formula because the dividend is expected to grow at 5% forever. Po = D1 / (r-g) = 1.05 / (0.188 0.05) = $7.61 The current market value of the firms equity is found by multiplying the number of shares outstanding by the price per share. The current market value is $7,610,000. (1,000,000 * $7.61)

Now you should calculate the capital structure weights of debt and equity. The first thing you need is the market value of the entire firm, or V. The market value of the entire firm is the market value of debt plus the market value of equity. The market value of the firm is $14,250,200 ($7,610,000 + $6,640,200). Weight of debt = 46.60% ($6,640,200 / $14,250,200) Weight of equity = 53.40% ($7,610,000 / $14,250,200) c. WACC = 0.5340 * 0.188 + 0.4660 * 0.1 * (1 0.34) = 0.1311 = 13.11%
NPV = -$30,000,000 + $2, 500, 000 / 13.11% = -$10,930,587

Do not take the project as NPV is negative. d. Since the core business is not related to the project, the WACC can not be used. Therefore, I can not draw any conclusions from the above analysis because it is incorrect.

5. Using the debt-equity ratio to calculate the WACC, we find: RWACC = (.65/1.65)(.055) + (1/1.65)(.15) = .1126 or 11.26% Since the project is riskier than the company, we need to adjust the project discount rate for the additional risk. Using the subjective risk factor given, we find: Project discount rate = 11.26% + 2.00% = 13.26% We would accept the project if the NPV is positive. The NPV is the PV of the cash outflows plus the PV of the cash inflows. Since we have the costs, we just need to find the PV of inflows. The cash inflows are a growing perpetuity. If you remember, the equation for the PV of a growing perpetuity is the same as the dividend growth equation, so: PV of future CF = $3,500,000/(.1326 .05) = $42,385,321 The project should only be undertaken if its cost is less than $42,385,321 since costs less than this amount will result in a positive NPV.

6.

MVB = 5,000($1,000)(1.03) = $5,150,000 MVS = 160,000($57) = $9,120,000

And the total market value of the firm is: V = $5,150,000 + 9,120,000 = $14,270,000 Now, we can find the cost of equity using the CAPM. The cost of equity is:

RS = .06 + 1.10(.07) = .1370 or 13.70% The cost of debt is the YTM of the bonds, so 7.70%. Now we have all of the components to calculate the WACC. The WACC is: RWACC = 0.077(1-35%)(5.15/14.27) + .1370(9.12/14.27) = .1056 or 10.56%

7. We are given the expected return and of a portfolio and the expected return and of assets in the portfolio. We know that the of the risk-free asset is zero. We also know the sum of the weights of each asset must be equal to one. So, the weight of the risk-free asset is one minus the weight of Stock X and the weight of Stock Y. Using this relationship, we can express the expected return of the portfolio as: E(Rp) = .1070 = wX(.172) + wY(.0875) + (1 wX wY)(.055) And the of the portfolio is: p = .8 = wX(1.8) + wY(0.50) + (1 wX wY)(0) We have two equations and two unknowns. Solving these equations, we find that: wX = 0.11111 wY = 2.00000 wRf = 0.88889 The amount to invest in Stock X is: Investment in stock X = 0.11111($100,000) = $11,111.11 A negative portfolio weight means that you short sell the stock. If you are not familiar with short selling, it means you borrow a stock today and sell it. You must then purchase the stock at a later date to repay the borrowed stock. If you short sell a stock, you make a profit if the stock decreases in value. The negative weight on the risk-free asset means that we borrow money to invest.

8 a) Here we have the expected return and beta for two assets. We can express the returns of the two assets using CAPM. If the CAPM is true, then the security market line holds as well, which means all assets have the same risk premium. Setting the reward-to-risk ratios of the assets equal to each other and solving for the risk-free rate, we find:

(.15 Rf)/1.4 = (.115 Rf)/.90 .90(.15 Rf) = 1.4(.115 Rf) .135 .9Rf = .161 1.4Rf .5Rf = .026

Rf = .052 or 5.20% Now using CAPM to find the expected return on the market with both stocks, we find: .15 = .0520 + 1.4(RM .0520) RM = .1220 or 12.20% .115 = .0520 + .9(RM .0520) RM = .1220 or 12.20%

b) 5.20% + 1.6 (12.20% 5.20%) = 5.20% + 11.20% = %16.40 c) 0.30 * 1.4 + 0.30*0.9 + 0.2*1 +0.2*0 = 0.89 d) According to SML 5.20% + 1.8 (12.20% - 5.20%) = 5.20% + 12.60% = 17.80%. The security is above SML. It is underpriced.