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Unformatted text preview: this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt. 5. 6. 7. RSup = .12 + .75(.08) = .1800 or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takes it. If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market’s valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division. The discount rate for the projects should be lower that the rate implied by the security market line. The security market line is used to calculate the cost of equity. The appropriate discount rate for projects is the firm’s weighted average cost of capital. Since the firm’s cost of debt is generally less that the firm’s cost of equity, the rate implied by the security market line will be too high. 8. 9. 10. Beta measures the responsiveness of a security's returns to movements in the market. Beta is determined by the cyclicality of a firm's revenues. This cyclicality is magnified by the firm's operating and financial leverage. The following three factors will impact the firm’s beta. (1) Revenues. The cyclicality of a firm's sales is an important factor in determining beta. In general, stock prices will rise when the economy expands and will fall when the economy contracts. As we said above, beta measures the responsiveness of a security's returns to movements in the market. Therefore, firms whose revenues are more responsive to movements in the economy will generally have higher betas than firms with less-cyclical revenues. (2) Operating leverage. Operating leverage is the percentage change in earnings before interest and taxes (EBIT) for a percentage change in sales. A firm with high operating leverage will have greater fluctuations in EBIT for a change in sales than a firm with low operating leverage. In this way, operating leverage magnifies the cyclicality of a firm's revenues, leading to a higher beta. (3) Financial leverage. Financial leverage arises from the use of debt in the firm's capital structure. A levered firm must make fixed interest payments regardless of its revenues. The effect of financial leverage on beta is analogous to the effect of operating leverage on beta. Fixed interest payments cause the percentage change in net income to be greater than the percentage change in EBIT, magnifying the cyclicality of a firm's revenues. Thus, returns on highly-levered stocks should be more responsive to movements in the market than the returns on stocks with little or no debt in their capital structure. 309 Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. With the information given, we can find the cost of equity using the CAPM. The cost of equity is: RE = .045 + 1.15(.11 – .045) = .1198 or 11.98% 2. With the information given, we can find the cost of equity using the dividend growth model. Using this model, the cost of equity is: RE = [$2.40(1.055)/$52] + .055 = .1037 or 10.37% 3. We have the information available to calculate the cost of equity using the CAPM and the dividend growth model. Using the CAPM, we find: RE = .05 + 0.85(.08) = .1180 or 11.80% And using the dividend growth model, the cost of equity is RE = [$1.60(1.06)/$37] + .06 = .1058 or 10.58% Both estimates of the cost of equity seem reasonable. If we remember the historical return on large capitalization stocks, the estimate from the CAPM model is about the same as the historical average, and the estimate from the dividend growth model is about one percent lower than the historical average, so we cannot definitively say one of the estimates is...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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