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.
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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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