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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View Full Document5.
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 tstatistic 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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 Net Present Value, rm – rf, rassets

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