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chap009_sm

# Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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CHAPTER 9 Capital Budgeting and Risk Answers to Practice Questions 1. a. r equity = r f + β × (r m – r f ) = 0.04 + (1.5 × 0.06) = 0.13 = 13% b. × + × = + = 0.13 \$10million \$6million 0.04 \$10million \$4million r V E r V D r equity debt assets r assets = 0.094 = 9.4% c. The cost of capital depends on the risk of the project being evaluated. If the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital. Here, the appropriate discount rate is 9.4%. d. r equity = r f + β × (r m – r f ) = 0.04 + (1.2 × 0.06) = 0.112 = 11.2% × + × = + = 0.112 \$10million \$6million 0.04 \$10million \$4million r V E r V D r equity debt assets r assets = 0.0832 = 8.32% 2. a. 0.729 n \$340millio n \$200millio 1.20 n \$340millio \$40million 0.20 n \$340millio n \$100millio 0 V C β V P β V D β β common preferred debt assets = × × × + × = × + × + × = b. r = r f + β × (r m – r f ) = 0.05 + (0.729 × 0.06) = 0.09374 = 9.374% 3. Internet exercise; answers will vary. 4. Internet exercise; answers will vary. 72

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5. a. The R 2 value for Alcan was 0.15, which means that 15% of total risk comes from movements in the market (i.e., market risk). Therefore, 85% of total risk is unique risk. The R 2 value for Inco was 0.22, which means that 22% of total risk comes from movements in the market (i.e., market risk). Therefore, 78% of total risk is unique risk. b. The variance of Alcan is: (24) 2 = 576 Market risk for Alcan: 0.15 × 576 = 86.4 Unique risk for Alcan: 0.85 × 576 = 489.6 The variance of Inco is: (29) 2 = 841 Market risk for Inco: 0.22 × 841 = 185.02 Unique risk for Inco: 0.78 × 841 = 655.98 c. The t-statistic for β INCO is: 1.04/0.26 = 4.09 This is significant at the 1% level, so that the confidence level is 99%. d. r AL = r f + β AL × (r m – r f ) = 0.05 + [0.69 × (0.12 – 0.05)] = 0.0983 = 9.83% e. r IN = r f + β IN × (r m – r f ) = 0.05 + [0.69 × (0 – 0.05)] = 0.0155 = 1.55% 6. Internet exercise; answers will vary. 7.
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chap009_sm - CHAPTER 9 Capital Budgeting and Risk Answers...

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