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# CH9 - CHAPTER 9 Capital Budgeting and Risk Answers to...

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CHAPTER 9 Capital Budgeting and Risk Answers to Practice Questions 1. It is true that the cost of capital depends on the risk of the project being evaluated. However, if the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital. 2. Internet exercise; answers will vary. 3. Internet exercise; answers will vary. 4. a. Both British Petroleum and British Airways had R 2 values of 0.25, which means that, for both stocks 25% of total risk comes from movements in the market (i.e., market risk). Therefore, 75% of total risk is unique risk. b. The variance of British Petroleum is: (25) 2 = 625 Unique variance for British Petroleum is: (0.75 × 625) = 468.75 c. The t-statistic for β BA is: (0.90/0.17) = 5.29 This is significant at the 1% level, so that the confidence level is 99%. d. r BP = r f + β BP × (r m - r f ) = 0.05 + (1.37) × (0.12 – 0.05) = 0.1459 = 14.59% e. r BP = r f + β BP × (r m - r f ) = 0.05 + (1.37) × (0 – 0.05) = -0.0185 = -1.85% 5. Internet exercise; answers will vary. 6. If we don’t know a project’s β , we should use our best estimate. If β ’s are uncertain, the required return depends on the expected β . If we know nothing about a project’s risk, our best estimate of β is 1.0, but we usually have some information on the project that allows us to modify this prior belief and make a better estimate. 82

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7. a. The total market value of outstanding debt is 300,000 euros. The cost of debt capital is 8 percent. For the common stock, the outstanding market value is: (50 euros × 10,000) = 500,000 euros. The cost of equity capital is 15 percent. Thus, Lorelei’s weighted-average cost of capital is: ) (0.15 500,000 300,000 500,000 (0.08) 500,000 300,000 300,000 r assets × + + × + = r assets = 0.124 = 12.4% b. Because business risk is unchanged, the company’s weighted-average cost of capital will not change. The financial structure, however, has changed. Common stock is now worth 250,000 euros. Assuming that the market value of debt and the cost of debt capital are unchanged, we can use the same equation as in Part (a) to calculate the new equity cost of capital, r equity : ) equity r ( 250,000 300,000 250,000 (0.08) 250,000 300,000 300,000 0.124 × + + × + = r equity = 0.177 = 17.7% 8. a. r BN = r f + β BN × (r m - r f ) = 0.035 + (0.64 × 0.08) = 0.0862 = 8.62% r IND = r f + β IND × (r m - r f ) = 0.035 + (0.50 × 0.08) = 0.075 = 7.50% b. No, we can not be confident that Burlington’s true beta is not the industry average. The difference between β BN and β IND (0.14) is less than one
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