CHAPTER 10

Exercise 9: The total market value of the common stock of the Okefenokee Real Estate
Company is $6 million, and the total value of its debt is $4 million. The treasurer
estimates that the beta of the stock is currently 1.5 and that the expected risk premium on
the market is 6 percent. The Treasury bill rate is 4 percent. Assume for simplicity that
Okefenokee debt is risk-free and the company does not pay tax.

Problem setting:
(a) Stock value = $6 million
(b) Debt value = $4 million
(c) Company value=D+E= $10 million
(d) β=1.5
(e) MRP=6%
(f) Risk-free rate= 4%

a. What is the required return on Okefenokee stock?

requity = rf + β × (rm – rf) = 0.04 + (1.5 × 0.06) = 0.13 = 13%

b. Estimate the company cost of capital.

D E ⎛ $4million ⎞ ⎛ $6million ⎞
rassets = rdebt + requity = ⎜ × 0.04 ⎟ + ⎜ × 0.13 ⎟
V V ⎝ $10million ⎠ ⎝ $10million ⎠

rassets = 0.094 = 9.4%

c. What is the discount rate for an expansion of the company’s present business?

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. Suppose the company wants to diversify into the manufacture of rose-colored

spectacles. The beta of unleveraged optical manufacturers is 1.2. Estimate the
required return on Okefenokee’s new venture.

requity = rf + β × (rm – rf) = 0.04 + (1.2 × 0.06) = 0.112 = 11.2%

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 D E ⎛ $4million ⎞ ⎛ $6million ⎞
rassets = rdebt + requity = ⎜ × 0.04 ⎟ + ⎜ × 0.112 ⎟
V V ⎝ $10million ⎠ ⎝ $10million ⎠

rassets = 0.0832 = 8.32%

Exercise 10: Nero Violins has the following capital structure:

Security Beta Total Market Value

($ Millions)
Debt 0 $100
Preferred stock 0.20 $40
Common stock 1.20 $299

Problem setting:
(a) Debt value= $100 million
(b) Preferred Stock value = $40 million
(c) Common Stock value = $299 million
(d) Company value=D+PE+CE= $439 million

a. What is the firm’s asset beta? Hint: What is the beta of a portfolio of all the firm’s
securities?

⎛ D⎞ ⎛ P⎞ ⎛ C⎞
β assets = ⎜ β debt × ⎟ + ⎜ β preferred × ⎟ + ⎜ β common × ⎟ =
⎝ V⎠ ⎝ V⎠ ⎝ V⎠
⎛ $100million ⎞ ⎛ $40million ⎞ ⎛ $299million ⎞
⎜0 × ⎟ + ⎜ 0.20 × ⎟ × ⎜1.20 × ⎟ = 0.836
⎝ $439million ⎠ ⎝ $439million ⎠ ⎝ $439million ⎠

b. Assume that the CAPM is correct. What discount rate should Nero set for investments
that expand the scale of its operations without changing its asset beta? Assume a risk-
free interest rate of 5 percent and a market risk premium of 6 percent.

r = rf + β × (rm – rf) = 0.05 + (0.836× 0.06) = 0.10016 = 10.016%

Exercise 13: see Lecture slides

Exercise 15: You are given the following information for Fleece Financial Corp.

Long-term debt outstanding $300,000

Current yield to maturity (rdebt) 8%

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 Number of shares of common stock 10,000
Price per share $50
Book Value per share $25
Expected return on stock (requity) 15%

Calculate Fleece’s company cost of capital. Ignore taxes.

Problem setting:
a) Market value of outstanding debt= $300,000
b) Cost of debt capital= 8%
c) Common stock market value is= $50 × 10,000 = $500,000
d) Cost of equity capital= 15%
e) Company value= $800,000

Thus, Fleece’s weighted-average cost of capital is:

⎛ 300,000 ⎞ ⎛ 500,000 ⎞
rassets = ⎜⎜ ⎟⎟ × 0.08 + ⎜⎜ ⎟⎟ × 0.15
⎝ 300,000 + 500,000 ⎠ ⎝ 300,000 + 500,000 ⎠

rassets = 0.12375 = 12.4%

Exercise 16: Look again at Table 10.1. This time we will concentrate in Burlington
Northern.

Table 9.1

Reference βequity Standard

Error
Burlington Northern & Santa Fe 0.83 0.19
Industry portfolio 0.87 0.16

a. Calculate Burlington’s cost of equity from the CAPM using its own beta estimate and
the industry beta estimate. How different are your answers? Assume a risk-free rate
of 5% and a market risk premium of 7%.

rBN = rf + βBN × (rm – rf) = 0.05 + (0.83 × 0.07) = 0.1081 = 10.81%

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 rIND = rf + βIND × (rm – rf) = 0.05 + (0.87 × 0.07) = 0.1109 = 11.09%

b. Can you be confident that Burlington’s true beta is not the industry average?

No, we cannot be confident that Burlington’s true beta is not the industry average. The
difference between βBN and βIND (0.04) is less than one standard error (0.19), so we
cannot reject the hypothesis that βBN = βIND.

c. Under what circumstances might you advice Burlington to calculate its cost of equity
based on its own beta estimate?

Burlington’s beta might be different from the industry beta for a variety of reasons. For
example, Burlington’s business might be more cyclical than is the case for the typical firm
in the industry. Or Burlington might have more fixed operating costs, so that operating
leverage is higher. Another possibility is that Burlington has more debt than is typical for
the industry so that it has higher financial leverage.

Exercise 19: An oil company is drilling a series of new wells on the perimeter of a
producing oil field. About 20 percent of the new wells will be dry holes. Even if a new
well strikes oil, there is still uncertainty about the amount of oil produced: 40 percent of
new wells that strike oil produce only 1,000 barrels a day; 60 percent produce 5,000
barrels per day.

a. Forecast the annual cash revenues from a new perimeter well. Use a future oil
price of $15 per barrel.

Expected daily production = (0.2 × 0) + 0.8 × [(0.4 x 1,000) + (0.6 x 5,000)] = 2,720
barrels.

Expected annual cash revenues = 2,720 x 365 x $15 = $14,892,000

b. A geologist proposes to discount the cash flows of the new wells at 30 percent to
offset the risk of dry holes. The oil company’s cost of capital is 10 percent. Does
this proposal make sense? Briefly explain why or why not.

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 The possibility of a dry hole is a diversifiable risk and should not affect the discount
rate. This possibility should affect forecasted cash flows, however. See Part (a).

Exercise 21: see Lecture slides

Exercise 22: The McGregor Whisky Company is proposing to market diet scotch. The
product will first be test-marketed for two years in southern California at an initial cost
of $500,000. This test launch is not expected to produce any profits but should reveal
consumer preferences. There is a 60 percent chance that demand will be satisfactory.
In this case McGregor will spend $5 million to launch the scotch nationwide and will
receive an expected annual profit of $700,000 in perpetuity. If demand is not
satisfactory, diet scotch will be withdrawn.

Once consumer preferences are known, the product will be subject to an average
degree of risk, and, therefore, McGregor will require a return of 12 percent on its
investment. However, the initial test-market phase is viewed as much riskier, and
McGregor demands a return of 40 percent on this initial expenditure.

What is the NPV of the diet scotch project?

At t = 2, there are two possible values for the project’s NPV:

(a) With 40% of probabilities (so that demand is not satisfactory), the NPV of the project
will be:

NPV2 ( if test is not successful) = 0

(b) With 60% of probabilities (so that demand is satisfactory), the NPV of the project will
be:

700,000
NPV2 ( if test is successful) = − 5,000,000 + = $833,333
0.12

Therefore, at t = 0:

(0.40 × 0) + (0 .60 × 833,333)

NPV0 = − 500,000 + = − $244,898
1.40 2