Rasmussen College - BUS 330 - Week 4 Assignment

Problem 1
1.
a. Calculate the yearly returns for both stocks
Year
Stock Price
A
Yearly
Return (%)
Stock Price
B
1 100 $ 65 $
2 112 $ 12.0% 70 $
3 118 $ 5% 79 $
4 106 $ -10% 83 $
5 110 $ 4% 80 $
6 91 $ -17% 95 $
7 105 $ 15% 94 $
8 125 $ 19% 108 $
9 155 $ 24% 120 $
10 185 $ 19% 125 $
b. Calculate the average yearly returns:
7.9%
c. Calculate the standard deviation:
14.0%
d. Which if these stocks was less risky? Explain
More the standard deviation, more risky the stock is. Stock A is considered to be more risky than B as its SD is more than B and returns are in the same range.
Below you are presented with hypothetical stock prices for two different stocks over a ten year period.
Yearly Return
(%)
8%
13%
5%
-4%
19%
-1%
15%
11%
4%
7.8%
7.4%
More the standard deviation, more risky the stock is. Stock A is considered to be more risky than B as its SD is more than B and returns are in the same range.
Below you are presented with hypothetical stock prices for two different stocks over a ten year period.
Rasmussen College - BUS 330 - Week 4 Assignment
Problem 2
2
a. Provide the CAPM equation and use it to solve for the required return of the company's equity.
CAPM Equation: re = rf + Beta (rm - rf)
Required Return: 10.30%
b. Now assume the beta is 1.6. What is the required return of the company's equity?
Required Return: 17.10%
c. What happens as beta increases?
Assume the risk-free rate is 3.5%, the beta of a company is 0.8 and the market-level return is 12%.
When beta increases, the requires rate of return increases. In other words, when beta increases the risk associated with the
investment increases which in turn increases the required return. This is clear from the above calculation, when risk was low that is
when beta was 0.8 the required return was only 10.30%, with the increase in risk that is beta at 1.16, the requried rate of return is
17.10%. Thus, when beta increases risk will increase which will increase the equtiy's required return.
a. Provide the CAPM equation and use it to solve for the required return of the company's equity.
Assume the risk-free rate is 3.5%, the beta of a company is 0.8 and the market-level return is 12%.
When beta increases, the requires rate of return increases. In other words, when beta increases the risk associated with the
investment increases which in turn increases the required return. This is clear from the above calculation, when risk was low that is
when beta was 0.8 the required return was only 10.30%, with the increase in risk that is beta at 1.16, the requried rate of return is
17.10%. Thus, when beta increases risk will increase which will increase the equtiy's required return.
Rasmussen College - BUS 330 - Week 4 Assignment
Problem 3
3.
a. Calculate the company's overall cost of capital.
Cost of Debt:
Pre-tax Cost of Debt 8.00%
Tax Rate 40.00%
After-tax Cost of Debt 4.80%
Cost of Equity:
Cost of Equity 11.00%
Weights:
Dollar Value ($
in millions) % Amount
Debt 50 $ 33.3%
Equity 100 $ 66.7%
Total 150 $ 100.0%
Cost of Capital:
Formula:
Calculation: 8.93%
b. What happens to the cost of equity as more debt gets used relative to equity? Why does this occur?
Nessumsar compay develops educational materials. It has a pre-tax cost of debt of 8.0% and a cost of equity of 11.0%. It has a marginal
tax rate of 40%, $50 million of debt and $100 million of equity.
Whenever proportion of debt increases when compared to equity, the cost of equtiy will increase because when debt increases, the risk associated with equity
investment also increases, which in turn will increase the cost of equity. Interest is a fixed obligation which has to be paid irrespective of profit/loss and equity
investor will get only residual income. In this case, when debt increases the financial distreass cost also increases which increases the cost of equity. A simple risk
and return concept.
WACC = (After tax cost of debt * Weight of debt)+(Cost of equtiy * Weight of equity) = (Kd*(1-T)*Wd)+(Ke*We)
b. What happens to the cost of equity as more debt gets used relative to equity? Why does this occur?
Nessumsar compay develops educational materials. It has a pre-tax cost of debt of 8.0% and a cost of equity of 11.0%. It has a marginal
tax rate of 40%, $50 million of debt and $100 million of equity.
Whenever proportion of debt increases when compared to equity, the cost of equtiy will increase because when debt increases, the risk associated with equity
investment also increases, which in turn will increase the cost of equity. Interest is a fixed obligation which has to be paid irrespective of profit/loss and equity
investor will get only residual income. In this case, when debt increases the financial distreass cost also increases which increases the cost of equity. A simple risk
and return concept.
WACC = (After tax cost of debt * Weight of debt)+(Cost of equtiy * Weight of equity) = (Kd*(1-T)*Wd)+(Ke*We)