Midterm_Solutions[1]

Midterm_Solutions[1] - = WACC r Problem III The differences...

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ACTSC 372 - Winter 2008 Midterm Solutions Problem I: 1. The weight of security 1 is given by % 50 1000 1000 1000 = + Therefore, the beta of the portfolio is: 1 = % 50 % 50 2 1 × + × β However, 8 . 0 1 = Thus, 2 . 1 1 = 2. The risk-free rate is 5% According to the CAPM, [ ] [ ] ( ) f m f r R E r R E - + = 1 1 Therefore, [ ] [ ] % 25 . 11 % 5 8 . 0 % 5 % 10 1 1 = + - = + - = f f m r r R E R E On the other hand, we have: [ ] [ ] ( ) ( ) % 5 . 12 % 5 % 25 . 11 2 . 1 % 5 2 2 = - × + = - + = f m f r R E r R E Problem II: 1. The firm’s cost of equity capital is equal to [ ] ( ) % 25 % 10 2 % 5 = × + = - + = f m f S r R E r r 2. The weighted average cost of capital (WACC) for this project will be equal to the WACC of the firm: ( ) S B C WACC r S B S r T S B B r × + + × - × + = 1 But, % 25 = S r and 2 1 = + S B B (because the debt-to-equity ratio is 1). Also, [ ] ( ) % 8 % 10 3 . 0 % 5 = × + = - + = f m debt f B r R E r r Therefore: ( ) % 1 . 15 % 25 2 1 % 8 35 . 0 1 2 1 = × + × - ×

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Unformatted text preview: = WACC r Problem III: The differences between common stock and debt for the firm could be: 1. No default for dividends if common stock; possible default for debt however; 2. Tax benefits for coupon payment of debt, but no tax benefit for stock’s dividends; 3. Shareholders own the company’s business, while debtholders do not; 4. If the company were to default, debtholders have a privilege over shareholders; 5. Shareholders have control rights over the company’s business (board of directors), while debtholders do not....
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This note was uploaded on 01/17/2011 for the course ACTSC 372 taught by Professor Maryhardy during the Spring '09 term at Waterloo.

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Midterm_Solutions[1] - = WACC r Problem III The differences...

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