Problem Set on Chapter 9.

CAPM, beta, and WACC

1. Bradshaw Steel has a capital structure with 30 percent debt (all long-term bonds) and 70 percent common equity. The yield to maturity on the companys long-term bonds is 8 percent, and the firm estimates that its overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent, the market risk premium is 5 percent, and the companys tax rate is 40 percent. Bradshaw uses the CAPM to determine its cost of equity. What is the beta on Bradshaws stock?

Beta risk 2. Sun State Mining Inc., an all-equity firm, is considering the formation of a new division that will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U. S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

Risk-adjusted discount rate 3. Assume you are the director of capital budgeting for an all-equity firm. The firms current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firms assets currently have, that is, its beta is 50 percent larger than the firms existing beta. The expected return on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure?

Pure play method 4. Interstate Transport has a target capital structure of 50 percent debt and 50 percent common equity. The firm is considering a new independent project that has an expected return of 13 percent and is not related to transportation. However, a pure play proxy firm has been identified that is exclusively engaged in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and Interstates before-tax cost of debt is 12 percent. The risk-free rate is 10 percent and the market risk premium is 5 percent. What should the firm do?
Longstreet Corporation has a target capital structure that consists of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has projects in which it would like to invest with costs that total $1,500,000. Longstreet will retain $500,000 of net income this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, the flotation costs are 10 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no

5.

flotation costs.) What is the weighted average cost of capital at the firms optimal capital budget?

6.

Lamonica Motors just reported earnings per share of $2.00. The stock has a price earnings ratio of 40, so the stocks current price is $80 per share. Analysts expect that one year from now the company will have an EPS of $2.40, and it will pay its first dividend of $1.00 per share. The stock has a required return of 10 percent. What price earnings ratio must the stock have one year from now so that investors realize their expected return? Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The companys common stock trades at $30 a share, and its current dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the companys tax rate? Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns: Expected Project Cost Return A $2,000 16.0% B 3,000 14.5 C 5,000 11.5 D 3,000 9.5 The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share (D1 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The companys stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?

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8.

Solutions to Problem Set Ch. 10

1.

CAPM, beta, and WACC Data given: Step 1: wd = 0.3; wc = 0.7; kd = 8%; T = 0.4; kRF = 5.5%, kM - kRF = 5%.

Determine the firms cost of equity using the WACC equation: WACC = wd kd (1 - T) + wc ks 10% = 0.3 8% (1 - 0.4) + 0.7 ks 8.56%= 0.7 ks ks = 12.2286%. Calculate the firms beta using the CAPM equation: ks = kRF + (kM - kRF)b 12.2286% = 5.5% + (5%)b 6.7286% = 5%b b = 1.3457 1.35.

Step 2:

2.

Beta risk Old assets = 1.0. New assets = 0.5. Total assets = 1.5. Old required rate: New required rate: 18% = 7% + (5%)b 16% = 7% + (5%)b beta = 2.2. beta = 1.8. New b must not be greater than 1.8, therefore 1 0.5 (2.2) + (b) = 1.8 1.5 1.5 0.3333(b) = 0.3333 b = 1.0. Therefore, beta of the new division cannot exceed 1.0.

3.

Risk-adjusted discount rate Calculate the beta of the firm, and use to calculate project beta: ks = 0.16 = 0.10 + (0.05)bFirm. bFirm = 1.2. bProject = (bFirm)1.5. (bProject is 50% greater than current bFirm) bProject = (1.2)1.5 = 1.8. Calculate required return on project, kProject, and compare to expected return: Project: kProject = 0.10 + (0.05)1.8 = 0.19 = 19%. Expected return = 0.18 = 18%. Since the required return is one percentage point greater than the expected return, the firm should not accept the new project.

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Pure play method Calculate the required return, ks, and use to calculate the WACC: ks = 10% + 1.38(5%) = 16.9%. WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%. Compare expected project return, k Project , to WACC: But k = IRR = 13.0%.
Project

Accept the project since IRRProject > WACC: 5. WACC

13.0% > 12.05%.

First, calculate the after-tax component cost of debt as 7%(1 0.3) = 4.9%. Next, calculate the retained earnings breakpoint as $500,000/0.5 = $1,000,000. Thus, to finance its optimal capital budget, Longstreet must issue some new equity and flotation costs of 10% will be incurred. The cost of new equity is then [$5(1.10%)/$75(1 - 0.1)] + 10% = 8.15% + 10% = 18.15%. Finally, the WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%. 6. Expected return and P/E ratio Data given: EPS = $2.00; P/E = 40; P0 = $80; D1 = $1.00; ks = 10%; EPS1 = $2.40. Step 1: Calculate the price of the stock one year from today: ks = D1/P0 + (P1 - P0)/P0 0.10 = $1/$80 + (P1 - $80)/$80 8 = $1 + P1 - $80 $87 = P1. Calculate the P/E ratio one year from today: P/E = $87/$2.40 = 36.25.

Step 2: 7. WACC

Capital structure: 40% D, 10% P, 50% E. WACC = 12.30% (given). kd = 11% (given). WACC = 0.4(kd)(1 - T) + 0.1(kp) + 0.5(ke). Because the firm has insufficient retained earnings to fund the equity portion of the firms capital budget, use ke in the WACC calculation. a. Calculate ke: $2(1.08) ke = + 8% = 8.47% + 8% = 16.47%. $30(0.85) b. Calculate kp: kp =
Dp PN

$2 = 11.11%. $20(0.9)

c. Find T by substituting values for kd, kp, and ke in the WACC equation: 0.1230 = 0.4(0.11)(1 - T) + 0.1(0.1111) + 0.5(0.1647) 0.1230 = 0.044(1 - T) + 0.0111 + 0.0824

0.0295 = 0.044(1 - T) 0.6713 = 1 - T 0.3287 = T. 8. WACC and cost of preferred We need to find kp at the point where all 4 projects are accepted. In other words, the capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is equal to IRRD = 9.5%. Step 1: Find the retained earnings break point to determine whether ks or ke is used in the WACC calculation: $1,000 BPRE = = $2,500. 0.4 Since the capital budget > the retained earnings break point, k e is used in the WACC calculation. Step 2: Calculate ke: ke = $3.00 + 5% = 12.80%. $42.75(0.9)

Step 3: Find kp: 9.5% = 0.4(10%)(0.65) + 0.2(kps) + 0.4(12.80%) 9.5% = 2.60% + 0.2(kps) + 5.12% 1.78% = 0.2kp 8.90% = kp.