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CHAPTER 8 ESTIMATING RISK PARAMETERS AND COSTS OF FINANCING Problem 1 We use the CAPM: The Expected Return on the stock = 0.058 + 0.95(0.0876) = 0.1412 = 14.12%. Since the investor is a short-term investor, we use the T-bill rate, and the arithmetic mean. Since the focus is short-term, we don’t need to take compounding into account. For a long-term investor, we would use the T-bond rate, and the geometric mean: The expected return 0.064 + 0.95(0.055) = 0.1163 or 11.63%. The cost of equity for the company is more appropriately the long-term required rate of return, since most projects for the company would be long-term. Problem 2 The levered beta of the company is given by formula: )) / )( 1 ( 1 ( L E D t u - + = . Solving, we get β unlevered = 0.95/(1+(1-0.36)(1.7/1.5)) = 0.55 The proportion of the risk of the firm’s equity that can be attributed to business risk is 0.55/0.95 = 58%, while the remainder is due to financial leverage risk. Problem 3 a. The cost of equity equals 0.064 + 1.70(0.055) = 15.75% b. If long term bond rates rise to 7.5%, the cost of equity will rise by a like amount to 16.85%. c. Since Biogen had no debt, all of its risk is due to business risk. Problem 4 a. The expected return on the stock, assuming that the marginal investor is a Malaysian with primarily domestic holdings is 0.115 + 1.15(0.12) = 25.30%, using the risk premium based on country risk provided by ratings agencies. b. For an international investor, who has the ability to diversify globally, some of the risk might be diversifiable, and hence the true beta might be lower. To take care of this possible overstatement, it would be appropriate to compute a beta relative to a more global index, such as the Morgan Stanley Capital Index. Problem 5
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Dividend Discount Models 2 a. Using the CAPM, we compute the expected return as 0.03 + 1.2(0.0876) = 13.51%. We use a T-bill rate, because the focus is on the short-term expected return (the next year). For the same reason, we use the market premium over bills. b. The cum-dividend price, one year from now, would be $50 (1.1351) = 56.75. The ex- dividend price, assuming that the stock price goes down by the amount of the dividend is 56.75 – 2.50 = $54.25. c. Over last year, the expected return would have been 15.51%, based on the prevailing T- bill rate then of 5%. d. The actual returns were (-4+2)/54 = -3.70% e. The unlevered beta based on the current capital structure would be 1.2/(1+(1- 0.4)(50/100)) = 0.92. There is no debt in the new capital structure. Hence the new beta would be 0.92. Problem 6 It’s current levered beta is 1.2. Using the formula for leveraging a beta )) / )( 1 ( 1 ( L E D t u - + = , we find the unlevered beta = 1.2/(1+(1-0.4)(50/100)) = 0.92. If the D/E ratio is increased to 8, we have the new levered beta equal to 0.92(1+(1-0.4)8) =
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This note was uploaded on 06/09/2011 for the course FINS 3641 taught by Professor Xx during the Three '11 term at University of Sydney.

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