Economics 282: ST - The Economics of Risk Management and Firms Tutorial #10 1.

Suppose a firm uses its company cost of capital to evaluate all projects. Will it underestimate or overestimate the value of high-risk projects? The company cost of capital underestimate the project cost of capital of high-risk projects. This will overestimate the PV of high-risk projects. 2. A firm is considering the following projects Project A & ) + eta #.$ 1.' 1.* #., !"pected returns 11% 1(% 1*% 12%

-he firm.s cost of capital is 1/%. -he risk free rate is /% and the e"pected market risk premium is ,%. 0a1 Which project will 2e accepted if the firm.s cost of capital is used for making investment decision? 021 Which project should 2e accepted? !a" and # will $e accepted. !$" % and & should $e accepted. #ost of capital for project % is '()0.*!+(" , +.'(. Project % has e-pected return greater than the opportunity cost of capital. as a result it has positive /PV0 and should $e accepted. 1imilarly0 calculate the costs of capital for projects 0 #0 and &. /PVs for and # are negative. /PV for & is positive. /. A company is financed '#% 2y risk-free de2t. -he risk-free rate is 1#%3 the e"pected market return is 1*%3 and the stock.s 2eta is #.(. )alculate the company.s cost of capital. %sset $eta is the weighted average of de$t $eta and e2uity $eta. Asset = 0 0.4 + 0.5 0.6 = 0.3 . #ompany cost of capital , 10( ) 0.'!13( - 10(" , 14.5(. '. 4irm 5 has the following capital structure Security +e2t 7referred stock Beta # #.2# Total market value 61## 6'#

)ommon stock

1.2#

628#

0a1 What is the firm.s asset 2eta? 021 Assume that the )A79 is correct. What discount rate should the firm set for investments that e"pand the scale of its operations without changing its asset 2eta? Assume the risk free rate is (% and the market risk premium is 8%. D P C assets = debt + preferred + common = V V V 0a1 0 100 + 0.20 40 1.20 260 = 0.802 400 400 400 !$" r , rf ) !rm 6 rf" , 7( ) !0.304 8(" , +.314(