chap012

# chap012 - Chapter 12 Risk Return and Capital Budgeting 12.1...

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¨ ? * Chapter 12: Risk, Return, and Capital Budgeting 12.1 Cost of equity R S = 5 + 0.95 (9) = 13.55% NPV of the project = -\$1.2 million + \$340, . 000 11355 1 5 t t = = -\$20,016.52 Do not undertake the project. 12.2 a. R D = (-0.05 + 0.05 + 0.08 + 0.15 + 0.10) / 5 = 0.066 R M = (-0.12 + 0.01 + 0.06 + 0.10 + 0.05) / 5 = 0.02 b. D R - D R M R - R M ( M R - M R ) 2 ( D R - R D )( M R - R M ) -0.116 -0.14 0.0196 0.01624 -0.016 -0.01 0.0001 0.00016 0.014 0.04 0.0016 0.00056 0.084 0.08 0.0064 0.00672 0.034 0.03 0.0009 0.00102 0.0286 0.02470 Beta of Douglas = 0.02470 / 0.0286 = 0.864 12.3 R S = 6% + 1.15 × 10% = 17.5% R B = 6% + 0.3 × 10% = 9% a. Cost of equity = R S = 17.5% b. B / S = 0.25 B / (B + S) = 0.2 S / (B + S) = 0.8 WACC = 0.8 × 17.5% + 0.2 × 9% (1 - 0.35) = 15.17% 12.4 C σ = ( 29 2 1 04225 . 0 = 0.065 M σ = ( 29 2 1 01467 . 0 = 0.0383 Beta of ceramics craftsman = CM ρ C σ M σ / M σ 2 = CM ρ C σ / M σ = (0.675) (0.065) / 0.0383 = 1.146 12.5 a. To compute the beta of Mercantile Manufacturing’s stock, you need the product of the deviations of Mercantile’s returns from their mean and the deviations of the market’s returns from their mean. You also need the squares of the deviations of the market’s returns from their mean. The mechanics of computing the means and the deviations were presented in an earlier chapter. Answers to End-of-Chapter Problems B-123

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R T = 0.196 / 12 = 0.016333 R M = 0.236 / 12 = 0.019667 E( T R - R T ) ( M R - R M ) = 0.038711 E( M R - R M ) 2 = 0.038588 β = 0.038711 / 0.038588 = 1.0032 b. The beta of the average stock is 1. Mercantile’s beta is close to 1, indicating that its stock has average risk. 12.6 a. R M can have three values, 0.16, 0.18 or 0.20. The probability that M R takes one of these values is the sum of the joint probabilities of the return pair that include the particular value of M R . For example, if M R is 0.16, R J will be 0.16, 0.18 or 0.22. The probability that M R is 0.16 and R J is 0.16 is 0.10. The probability that R M is 0.16 and R J is 0.18 is 0.06. The probability that M R is 0.16 and R J is 0.22 is 0.04. The probability that M R is 0.16 is, therefore, 0.10 + 0.06 + 0.04 = 0.20. The same procedure is used to calculate the probability that M R is 0.18 and the probability that M R is 0.20. Remember, the sum of the probability must be one. M R Probability 0.16 0.20 0.18 0.60 0.20 0.20 b. i. R M = 0.16 (0.20) + 0.18 (0.60) + 0.20 (0.20) = 0.18 ii.
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