Review Ans and Qs

Review Ans and Qs - FIN 6215 Corporate Financial Management...

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1 FIN 6215 Corporate Financial Management Scott Fung (2010) Problem Set and Review Exercises (with Solutions) Note: The following review questions are not homework; suggested solutions are provided for your review and study. Question 1 [Capital Budgeting] Projects A and B are mutually exclusive projects and expected to produce the following cash flows: Cash Flows Project C0 C1 C2 A -100 +110 +121 B -120 +110 +141 (a) Assume that the risky discount rate for project A is 13% and the risky discount rate for project B is 11%. Calculate the NPV of each project. Which project should the firm invest? Why? Calculate NPV of A based on discount rate of 13%. Calculate NPV of B based on discount rate of 11%. Firm should invest project which gives higher NPV (simple calculation here). Hint: Project A: using discount rate of 13%, NPV of A will be 92. (= -100 + 110/(1.13) + 121/(1.13)^2) Project B: using discount rate of 11%, NPV of B will be 93.5. Project B will be selected because of higher NPV (review lecture notes on “Capital Budgeting”) (b) Now, assume that either projects A or B can be financed by issuing equity. Assume that the opportunity cost of capital is 10%. Which project should the firm invest? Why? Calculate NPVs of A and B based on the same discount rate 10%. You will find reverse conclusion here compared to part (b). Hint: Project A: using discount rate of 10%, NPV of A will be 100 Project B: using discount rate of 10%, NPV of B will be 96.5 Project A will be selected because of higher NPV (review lecture notes on “Capital Budgeting”)
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2 Question 2 [CAPM and Betas] You have been asked to estimate the beta of a high-tech firm which has three divisions with the following characteristics: Division Beta Market Value Laptop 1.50 $ 120 m Digital Camera 1.90 $ 120 m Computer Software 1.40 $ 200 m (a) What is the beta of equity of the firm? Beta of equity of the firm = 1.50*(120/440)+ 1.90*(120/440)+ 1.40*(200/440) = 1.60 (b) If digital camera business is divested from the firm (such as a carve-out), which beta would you use in valuation of digital camera business? Why? If digital camera business is divested from the firm (such as a carve-out), use beta of 1.90. Because new shareholders for digital camera with carve-out. Question 3 [Betas and Financial Leverage] Following are betas of equity of 4 computer companies, and their debt/equity ratios. Firm Beta Debt/ Equity Ratio ICM 1.15 33.91% JMD 1.18 54.14% KK 1.05 45.05% SMG 0.91 11.29% Assume that all firms face a corporate tax rate (t C ) of 40%. Answer the following parts: (a) Estimate unlevered beta for each firm. What do the unlevered betas tell you about these firms? Unlevered Beta = Levered Beta / (1 + (1-40%)*D/E) See the definition and meaning of unlevered beta from powerpoint/lecture materials. for ICM, Unlevered Beta = 1.15 / (1 + (1-40%)*33.91%) = 0.96
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This note was uploaded on 03/17/2010 for the course BUS 10 taught by Professor Prowell during the Winter '08 term at CSU East Bay.

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Review Ans and Qs - FIN 6215 Corporate Financial Management...

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