ARE 171a
Fall 2011
Homework 4
Due Wednesday, Nov.
30, in class
1.
Consider 2 firms, which are identical except for their capital structure:
Firm A sold 20 million shares of stock @ $20/share (all-equity financed)
Firm B sold 10 million shares of stock @ $20/share, and $200 million in long term bonds at coupon rate
of 8%
In the upcoming year, suppose there is a 1/3 chance of a strong economy, a 1/3 chance of an average economy,
and a 1/3 chance of a weak economy.
In an average year, sales are $100 million, and cost of goods sold is 60%
of sales.
In a strong year, sales increase by 20% to $120 m., with a proportional increase in cost of goods sold.
In a weak year, sales decline by 20% to $80 m., with a proportional decrease in cost of goods sold.
In each
case, depreciation is $12 million, and taxes are 25% of EBT.
Find EAT, EPS, ROA, and ROE for each firm, under strong, average and weak economic conditions.
Now, find the mean, std. dev and coefficient of variation of EPS, for firm A and firm B.
What type of risk effect
does this illustrate?
2.
a.
Starwood Corp. recently paid a dividend of $0.80/share.
Its beta estimate is 1.2, and its expected
dividend growth is 5%.
Find investors’ required rate of return for this stock, and the stock’s current stock price,