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riskprac - Risk in Practice Solutions to Problems Problem 1...

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Risk in Practice: Solutions to Problems Problem 1 a. Expected Return to Short-term Investor = 5.8% + 0.95 (8.5%) = 13.88% (I am using the historical premium of 8.5% to estimate expected returns) b. Expected Return to Long-term Investor = 6.4% + 0.95 (5.5%) = 11.63% c. I would use the expected return of 11.63% as the cost of equity Problem 2 a. Unlevered Beta = 0.95 / (1 + (1- 0.36) (1700/1500)) = 0.55 b. The beta of 0.95 can be broken down into business risk (0.55) and financial risk (0.40). Problem 3 a. Cost of Equity = 6.40% + 1.70 (5.5%) = 15.75% b. If the long term bond rate rises to 7.5%, the cost of equity will rise by 1.1%. c. Since the firm had no debt, all of the risk can be attributed to business risk. Problem 4 a. Expected Return = 11.5% + 1.15 (7.50%) = 20.13% {I am using a premium of 7.50% for Malaysian stocks to reflect its higher risk.} b. This beta measures risk relative to a Malaysian index. For an international investor an more appropriate beta may be the one estimated relative to a global index. Problem 5 a. Expected Return = 3% + 1.2 (8.5%) = 13.20% b. Expected Price Appreciation = 13.20% - ($ 2.50 / $ 50) = 8.20% Expected Price one year from today = $ 50 (1.082) = 54.10 $ c. Expected Returns over last year = 5% + 1.20 (-5% - 5%) = -7.00% Returns on Market = -8% + 3% = -5% d. Actual Returns over last year = (50-54+2)/54 = -3.70% e. Unlevered Beta = 1.20 / (1+ (1-.4) (50/100)) = 0.923 If the firm issues $ 50 million in equity and retires debt, its beta will drop to 0.923 Problem 6 Unlevered Beta = 1.20 / (1 + (1-0.4) (50/100)) = 0.923076923 New Beta = 0.923 (1 + (1-0.4) (8)) = 5.35 Problem 7 a. Unlevered Beta for Novell = 1.50 ! Firm has no debt Unlevered Beta for WordPerfect = 1.30 ! Firm has no debt Unlevered Beta for Combined Firm = 1.50 (2/(2+1)) + 1.30 (1/(2+1)) = 1.43 This would be the beta of the combined firm if the deal is all-equity. b. If the deal is financed with debt, New Debt/Equity Ratio = 1/2 = 0.5 New Beta = 1.43 (1 + (1-.4) (0.5)) = 1.86 Problem 8 a. Beta for Hewlett Packard = 1.10 (2/8) + 1.50 (2/8) + 2.00 (1/8) + 1.00 (3/8) = 1.275 This beta may not be equal to the regression estimate of beta, because both of these are estimated with error b. Cost of Equity = 7.5% + 1.275 (5.5%) = 14.51% Mainframes Cost of Equity = 7.5% + 1.10 (5.5%) = 13.55% Personal Computers Cost of Equity = 7.5% + 1.5(5.5%) = 15.75% Software Cost of Equity = 7.5% + 2 (5.5%) =
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