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Financial Markets and Valuation - Tutorial 5: SOLUTIONS

Capital Asset Pricing Model, Weighted Average Cost of Capital &


Practice Questions
(*) denotes those problems to be covered in detail during the tutorial session

Capital Asset Pricing Model (CAPM)


Problem 1. (Ross, Westerfield & Jaffe) Suppose the risk-free rate is 6.3 % and the
market portfolio has an expected rate of return of 14.8 %. The market portfolio has a
variance of 0.0121. Portfolio Z has a correlation coefficient with the market of 0.45
and a variance of 0.0169. According to the CAPM, what is the expected rate of return
on portfolio Z?
Solution:

rf

[~
r m] = 14.8%

= 6.3%

z, m

= 0.45

z, m

2
z

m2

= 0.0121

= 0.0169

Cov (Rz , Rm )
(0.13)(0.11)
Cov (Rz , Rm ) = 0.006435

)
[rZ ] =

Cov (R Z , Rm )

2
m

0.006435
=
0.0121

0.532

6.3% + 0.532 [14.8% 6.3%] = 10.82%

(*) Problem 2. (Ross, Westerfield & Jaffe) Johnson Paint stock has an expected
return of 19 % with a beta of 1.7, while Williamson Tire stock has an expected return
of 14 % with a beta of 1.2. Assume the CAPM is true. What is the expected return on
the market? What is the risk-free rate?

Solution:
(~
r j ) = 19% = r f + 1.7 (~
r m) r f
~
(r w) = 14% = r f + 1.2 (~
r m) r f
r m) r
Equations (A) (B): 5% = 0.5 (~

Risk Premium:

[ (~r m) r ]

(~
r m)

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

Equation A

Equation B

= 10%
r f + 10%
1

Substituting into Equation (A) : r f + 1.7 r f + 10% r f


(~
r m ) = 12%
r
= 2%

= 19%

Problem 3. (Ross, Westerfield & Jaffe) Suppose


following four stocks.
Security
Amount invested
Stock A
$5,000
Stock B
10,000
Stock C
8,000
Stock D
7,000

you have invested $30,000 in the


Beta
0.75
1.10
1.36
1.88

The risk-free rate is 4 % and the expected return on the market portfolio is 15 %.
Based on the CAPM, what is the expected return on the above portfolio?
Solution:

(16 ) (0.75) + (13 ) (1.10) + (1.36) (415) + (7 30) (1.88)

=
~
(r ) =
=

1.293
4% + 1.293 [15% 4%]
18.22%

(*) Problem 4. (Ross, Westerfield & Jaffe) There are two stocks in the market, stock
A and stock B. The price of stock A today is $50. The price of stock A next year will
be $40 if the economy is in a recession, $55 if the economy is normal, and $60 if the
economy is expanding. The attendant probabilities of recession, normal times and
expansion are 0.1, 0.8 and 0.1, respectively. Stock A pays no dividend.

Assume the CAPM is true. Other information about the market includes:
(m) = 10%
(B) = 12 %
E(Rb) = 9 %

Correlation Coefficient (A, m) = 0.8


Correlation Coefficient (B, m) = 0.2
Correlation Coefficient (A, B) = 0.6
a. If you are a typical risk averse investor, which stock would you prefer? Why?
b. What are the expected return and standard deviation of a portfolio consisting of
70 % of stock A and 30 % of stock B?
c. What is the beta of the portfolio in part (b)?

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

Solution:

(a)

Price of Security A today =

$50

Expected Price of Security A next year =


(0.1)($40) + (0.8)($55) + (0.1)($60) = $54
$54 $50
$50

(~
rA ) =

= 8%

A2 = 0.1 [ 0.20 0.0 8]2 + 0.8 [0.10 0.0 8]2 + 0.1 [0.20 0.0 8]2
=

0.0096

A2

= 9 .8 %

A, m m A

2
m

0.8 0.1 0.098


=
0 .1 0 .1

0.784

The beta of stock B is:

B,M B
M

B,M M B
2M
0.20.12
0.10

0. 24

The return on stock B is higher than the return on stock A. The risk of stock B, as
measured by its beta, is lower than the risk of A. Thus, a typical risk-averse investor
will prefer stock B.
b.

E (Rp ) = 70% x E (Ra ) + 30% x E (Rb ) = 70% x 8% + 30% x 9% = 8.3%

~ ~

P = x12 12 + (1 x1 ) 2 22 + 2 x1 (1 x1 ) cov( R1 , R2 )
= [(0.7)2(0.098)2 + (0.3)2(0.12)2 + (2) (0.7)(0.3)(0.6*0.098*0.12) ]1/2
= (0.0089655)1/2 = 9.47%
c.

P =0.7*0.784+0.3*0.24=0.62

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

Weighted Average Cost of Capital (WACC)


Problem 5. (Ross, Westerfield & Jaffe) The equity beta of Adobe Online Company is
1.29. Adobe online has a debt-to-equity ratio of 1. The expected return on the market
is 13%. The risk free rate is 7%. The cost of debt capital is 7%. The corporate tax rate
is 35%.

(a) What is Adobe Onlines cost of equity?


(b) What is Adobe Onlines weighted average cost of capital?
Solution:

(a) Cost of Equity: 7 + 1.29 (13 7) = 14.74%


(b) B/(S+B) = S/(S+B) = 0.5
WACC = 0.5(7)(0.65) +0.5(14.74) = 9.645%

(*) Problem 6. (Ross, Westerfield & Jaffe) Calculate the WACC of the Luxury
Porcelain Company. The book value of Luxurys outstanding debt is $60 million.
Currently debt is trading at 120 percent of book value and is priced to yield 12
percent. The 5 million outstanding shares of Luxury stocks are selling for $20 per
share. The required return on Luxury stock is 18 percent. The tax rate is 25 percent.

Solution:

B = $60million * 1.2 = $72million


S = $20*5million = $100 million
B/(S+B) = 72 / 172 = 0.4186
S/(S+B) = 100/172 = 0.5814
WACC = 0.4186(12%)(0.75) + 0.5814(18%) = 14.23%

(*) Problem 7. (Ross, Westerfield & Jaffe) Calgary Industries, Inc., is considering a
new project that costs $25 million. The project will generate after-tax (year-end) cash
flows of $7 million for 5 years. The firm has a debt-to-equity ratio of 0.75. The cost of
equity is 15% and the cost of debt is 9%. The corporate tax rate is 35%. It appears that
the project has the same risk as that of the overall firm. Should Calgary take on the
project?

Solution:

B/S = 0.75
B/(S+B) = 3/7
S/(S+B) = 4/7

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

WACC = (4/7)15% + (3/7)(9%)(1-0.35) = 11.08%


5

NPV = $25million +
t =1

$7million

(1 + 0.1108)t

= $819,299.04
Therefore, the project should be undertaken.

(*) Problem 8. (Ross, Westerfield & Jaffe) National Electricity Company (NEC) is
considering a $20 million modernization expansion project in the power station
division. Tom Edison, the CFO, has evaluated the project; he determined that the
projects after-tax cash flow will be $8 million, in perpetuity. In addition, Mr. Edison
has devised two possibilities for raising the necessary $20 million:

Issue 10-year, 10% debt;


Issue common stock.

NECs cost of debt is 10% and its cost of equity is 20%. The firms target debt-equity
ratio is 200%. The expansion project has the same risk as the existing business, and it
will support the same amount of debt. NEC is in the 34% tax bracket.
Mr. Edison has advised the company to undertake the expansion. He suggests they
use debt to finance the project because it is cheaper and its issuance costs are lower.
(a) Should NEC accept the project? Support your answer with the appropriate
calculations?
(b) Do you agree with Mr. Edisons opinion of the expense of the debt? Why or
why not?
Solution:

(a) NECs debt equity ratio is 2. That means for every dollar of equity the firm
has, it has two dollars of debt. The debt to value ratio of the firm is B/(S+B)
which is equal to 2/(2+1) = 2/3. The equity to value ratio is 1/3. Thus, the
WACC is:
WACC = (2/3)(0.10)(1-0.34) + (1/3)(0.20) = 0.1107
Thus,
NPV = -$20million + ($8million/0.1107) = $52,267,389.34
Therefore, NEC should accept the project.

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

(b) Mr. Edisons conclusion is incorrect. Even though the issuing costs of debt are
far lower than those of equity, the firm must try and maintain its optimal
capital structure. Thus, anytime all debt financing is used, the firm will have to
issue more equity in the future to bring the capital structure back to the
optimal.

Revision Problems
Problem 9. (Ross, Westerfield & Jaffe) You are saving for the college education of
your two children. They are two years apart in age; one will begin college in 15 years,
the other in 17 years. You estimate your childrens college expenses to be $21,000 per
year per child. The annual interest rate is 15%, and it will remain 15% throughout the
next 25 years. How much money must you place in an account each year to fund your
childrens educations? You will begin payments one year from today. You will
discontinue payments when your oldest child enters college. Assume that the duration
of the college degree is 4 years for each child and that the fees are due and are paid at
the beginning of the college year.

Solution :

You have to pay $21,000 each year for 4 years, for each of your two children. The
first child will enter college in 15 years time while the second child will enter college
in 17 years time. You are to assume that the fees are due and paid at the beginning of
the college year.
Given an annual interest rate of 15% which is expected to remain constant through the
next 25 years, you are required to calculate the yearly payments (the first starting one
year from now) that you need to invest so as to be able to pay for both your childrens
education when it comes due. You will stop making these payments when the oldest
child enters college (i.e. 15 years from now)
The first thing you need to do is to calculate the present value of your total financial
obligation, as follows :
PV (first childs fees) =

$21,000 * PVAnnuityFactor (4 yrs,15%)

PV (second childs fees) =

14

(1.15)

= $8,473.36

$21,000 * PVAnnuityFactor (4 yrs,15%)


16

(1.15)

= $6,407.08

PV of total obligation = $8,473.36 + $6,407.08 = $14,880.44

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

The next step is to find the annuity payments starting one year from today. Let the
unknown annuity payment be $X, then
$14,880.44 = $X * PV Annuity Factor (15 years, 15%) = $X * 5.8474
$14,880.44
Re-arranging, $X =
= $2,544.80
5.8474
(*) Problem 10. (Ross, Westerfield & Jaffe) After extensive medical and marketing
research Pill, Inc. believes it can penetrate the pain reliever market. It can follow one
of two strategies. The first is to manufacture a medication aimed at relieving headache
pain. The second strategy is to make a pill designed to cure headache and arthritis
pain. Both products would be introduced at a price of 4 $ per package in real terms.
The broader remedy would probably sell 10 million packages a year. This is twice the
sales rate for the headache-only medication. Cash costs of production in the first year
are expected to be 1.50$ per package in real terms for the headache-only brand.
Production costs are expected to be 1.70$ in real terms for the more general pill. All
prices and costs are expected to rise at the general inflation rate of 5%.

Either strategy will require further investment in plant. The headache-only pill could
be produced using equipment that would cost 10.2 $ million, last three years and have
no resale value. The machinery required to produce the cure-all would cost 12$
million and last three years. At this time the firm would be able to sell it for $1
million in real terms. The production machinery would need to be replaced every
three years at constant real costs.
Suppose that for both projects the firm will use straight-line depreciation. The firm
faces a corporate tax rate of 34%. The firm believes the appropriate real discount rate
is 13%. Capital gains are taxed at the ordinary corporate tax rate of 34%. Which pain
reliever should the firm produce?

Solution:
We will solve the question using nominal quantities. The nominal discount rate is
(1 + inflation rate) x (1 + real rate) = 18.65%
Headache only
After tax operating income (using nominal prices and costs) is

qty
price
revenue
costs/unit
total cost
op. income
tax
NOPLAT

1
5000000
4.2
21000000
1.575
7875000
13125000
4462500
8662500

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006

2
5000000
4.41
22050000
1.65375
8268750
13781250
4685625
9095625

3
5000000
4.6305
23152500
1.736438
8682188
14470313
4919906
9550406

The total PV comes out to be:


PV = 8662500/1.1865 + 9095625/(1.1865)^2 + 9550406/(1.1865)^3
= $19,479,508.93
Depreciation tax shield:
In nominal terms, it is expected to be (10.2 million/3)*(0.34) = $1,156,000
Its total PV is $2,487,521.65
The NPV of the project, therefore, is
NPV = - $10,200,000 + $19,479,508.93 + $2,487,521.65
= $11,767,030
Headache & Arthritis only
After tax operating income (using nominal prices and costs) is

qty
price
revenue
costs/unit
total cost
op. income
tax
NOPLAT

1
10000000
4.2
42000000
1.785
17850000
24150000
8211000
15939000

2
10000000
4.41
44100000
1.87425
18742500
25357500
8621550
16735950

3
10000000
4.6305
46305000
1.967963
19679625
26625375
9052628
17572748

Total PV comes out to be $35,842,296.44


Depreciation tax shield:
In nominal terms, it is expected to be (12 million/3)*(0.34) = $1,360,000
Its total PV is $2,926,495.488
Revenue from the machine sale:
The machine would sell for $1,000,000 (1.05)3 = $1,157,625.
After tax value = $1,157,625(0.66) = $764,032.5
PV = $764,032.5/(1.1865^3) = $457,413.1071
NPV of this option is therefore:
-$12,000,000 + $35,842,296.44 + $2,926,495.488 + $457,413.1071
= $27,226,205.03
The firm should choose to manufacture the Headache & Arthritis drug.

FMV/Tutorial 5 Solutions/Sept.-Oct. 2006