# 3_answer - r = r f(r m – r f = 4 1.4(12 – 4 = 15.2...

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1 Tutorial 3: suggested solutions for selected questions 1. a. The expected cash flows from the firm are in the form of a perpetuity. The discount rate is: r f + (r m – r f ) = 4% + 0.4 (12% – 4%) = 7.2% Therefore, the value of the firm would be: 89 . 888 , 138 \$ 072 . 0 000 , 10 \$ r flow Cash P 0 b. If the true beta is actually 0.6, the discount rate should be: r f + (r m – r f ) = 4% + 0.6 (12% – 4%) = 8.8% Therefore, the value of the firm is: 36 . 636 , 113 \$ 088 . 0 000 , 10 \$ r flow Cash P 0 By underestimating beta, you would overvalue the firm by: \$138,888.89 – \$113,636.36 = \$25,252.53 2. Beta tells us how sensitive the stock return is to changes in market performance. The market return was 4 percent less than your prior expectation (10% versus 14%). Therefore, the stock would be expected to fall short of your original expectation by: 0.8 4% = 3.2% The ‘updated’ expectation for the stock return is: 12% – 3.2% = 8.8% 3. The appropriate discount rate for the project is:

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Unformatted text preview: r = r f + (r m – r f ) = 4% + 1.4 (12% – 4%) = 15.2% Therefore: Using financial calculator, NPV = –\$100 + [\$15 annuity factor(15.2%, 10 years)] = – \$25.29 OR Using our familiar PVA formula; 29 . 25 \$ 152 . 152 . 1 1 15 100 10 NPV 2 You should reject the project. 4. (a) Using the recent growth rate of 30% and the dividend yield of 2%, one estimate would be: DIV 1 /P + g = 0.02 + 0.30 = 0.32 = 32% Another estimate, based on the CAPM, would be: r = r f + (r m – r f ) = 4% + (1.2 8%) = 13.6% (b) The estimate of 32% seems far less reasonable. It is based on an historic growth rate that is impossible to sustain. The [DIV 1 /P + g] rule requires that the growth rate of dividends per share must be viewed as highly stable over the foreseeable future. In other words, it requires the use of the sustainable growth rate....
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## This note was uploaded on 10/08/2011 for the course FINANCE 101 taught by Professor Jannis during the Three '11 term at Monash.

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3_answer - r = r f(r m – r f = 4 1.4(12 – 4 = 15.2...

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