# Market risk premium rev 08282012 explanation r r f β

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Market risk premium % rev: 08_28_2012 Explanation: r = r f + β( r m r f ) 8 = r f + 0.2( r m − r f ) (stock A) 12 = r f + 1.8( r m r f ) (stock B) Solve these simultaneous equations to find that r f = 7.5% and r m = 10.0%. Market risk premium = r m r f = 10.0% − 7.5% = 2.5% Problem 12-29 CAPM (LO2) We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It prospers in recessions when other firms are struggling. Consequently, its beta is negative, −.2. a. If the interest rate on Treasury bills is 6% and the expected return on the market portfolio is 16%, what is the expected return on the shares of the law firm according to the CAPM? 650,000 ± 1% 10.0 ± 1% 2.5 ± 1%

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Expected return % b. Suppose you invested 80% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio? (Round your answer to 2 decimal places.) Portfolio beta Explanation: a. r = r f + β( r m r f ) = 6% + [(−0.2) × (16% − 6%)] = 4% b. Portfolio beta = (0.80 × β market ) + (0.20 × β law firm ) = (0.80 × 1.0) + [0.20 × (−0.2)] = 0.76 Problem 13-1 Cost of Debt (LO2) Micro Spinoffs, Inc., issued 10-year debt a year ago at par value with a coupon rate of 7%, paid annually. Today, the debt is selling at \$1,350. If the firm’s tax bracket is 40%, what is its after-tax cost of debt? (Do not round intermediate calculations. Round your answer to 2 decimal places.) After-tax cost of debt % rev: 04_23_2013_QC_28984, 10_03_2014_QC_55295 Explanation: Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations. The yield to maturity for the bonds (since maturity is now 9 years) is the interest rate ( r ) that is the solution to the following equation: [\$70 × annuity factor ( r , 9 years)] + [\$1,000/(1 + r ) 9 ] = \$1,350 Using a financial calculator, enter n = 9, FV = 1,000, PV = (−)1,350, PMT = 70; then compute i = 2.59%. Therefore, the after-tax cost of debt is 2.59% × (1 − 0.40) = 1.55%. Problem 13-2 Cost of Preferred Stock (LO2) Micro Spinoffs has preferred stock outstanding. The stock pays a dividend of \$12 per share, and the stock sells for \$50. What is the return on preferred stock? Return on preferred stock % 4 ± 1% 0.76 ± 1% 1.55 ± 1% 24 ± 1%
Explanation: r = DIV = \$12 = 0.24 = 24% P 0 \$50 Problem 13-3 Calculating WACC (LO3) Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon rate of 5%, paid annually. Today, the debt is selling at \$1,050. The firm’s tax bracket is 40%. Micro Spinoffs also has preferred stock outstanding. The stock pays a dividend of \$5 per share, and the stock sells for \$25. Micro Spinoffs’s cost of equity is 22%. What is its WACC if equity is 60%, preferred stock is 20%, and debt is 20% of total capital? (Do not round intermediate calculations. Round your answer to 2 decimal places.) WACC % Explanation: Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations.

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• Spring '11
• Woo
• Finance, Dividend yield, intermediate calculations

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