Analysis for Financial Management, 10e

SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS

CHAPTER 8

2. The numerator of Stock A’s beta = 22.9% (0.62 x 37%). The same quantity for Stock
B = 32.0% (0.94 x 34%).Because all betas share the same denominator, the stock with
the lower numerator has the lower beta. Thus, Stock B is the riskier asset. Stock A
has higher total risk but because its returns are relatively independent of those of a
diversified portfolio, it has lower systematic risk.

4. If the investment is above the company's average risk, its cost of capital is not an
appropriate benchmark. Equivalently, the high risk of the investment places it below
the market line. Such investments destroy value because they promise returns below
those available on available similar-risk investments. Other more prosaic arguments
include: the investment is not consistent with the strategic plan, the cash flow
estimates are too optimistic, and there are other mutually exclusive projects with
higher NPVs.

6. a. Using the perpetuity equation, IRR = 6.4/40=16%

b. Kw = [(1-.35)(7.5%)(290) + 14%(20 X 40)]/(290 + 20 X 40) = 11.6%. As long as

the market value of debt is given, you might as well use it. As usual, using the
book value instead doesn't make much difference. Using the book value, Kw =
11.4%.

c. IRR exceeds the WACC and the investment is average risk for the company, so it
should create value for owners.

8. Divide the cash flows into two periods: A 15-year annuity of $1,000, and a growing
perpetuity beginning in the 15th year. The value of the 15-year annuity is $6,462.38.

Input: 15 13 ? 1,000 --
n i PV PMT FV
Output: -6,462.38

The value of the growing perpetuity at time 15 is $1,000(1+.04)/(.13-.04) =

$11,555.56. Its value at time zero is $11,555.56/(1.13)15 = $1,847.63. Adding these
present values, $6,462.38 + $1,847.63 = $8,310.01.

10. A standard way to estimate an asset’s beta is to regress its returns against those of a
well-diversified portfolio. The slope of this regression line is the beta estimate. An
estimate of Berkshire Hathaway’s beta is thus 0.72.

12. See C8_Problem_12_Answer.xlsx on this Web site.

© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
14. a. Following the approach described in Table 8A.1, an average asset beta, weighted
by relative market values of equity, appears below. Other weighting schemes, or a
simple unweighted average, are also defensible.

Equity % total Weighted

Firm Beta Debt MVE E/V Asset beta MVE Asset beta
Black & Decker 1.19 $4,100 $6,300 0.606 0.721 38.78% 0.280
Fedders Corp. 1.20 5 200 0.976 1.171 1.23% 0.014
Helen of Troy
2.14 380 530 0.582 1.246 3.26% 0.041
Corp.
Salton, Inc. 3.25 375 115 0.235 0.763 0.71% 0.005
Whirlpool 1.83 10,600 9,100 0.462 0.845 56.02% 0.474
Industry
Asset Beta 0.814

b. The asset betas of the companies above vary within a reasonably narrow range,
providing some comfort that our calculated asset beta reflects the business risk of
the home appliance industry. However, we should also evaluate the extent to
which these comparable companies are engaged in other, different-risk industries.
To the extent they are active in other businesses unrelated to home appliances,
they are less comparable to Dome Appliance.

16. a. Asset beta = (E/V) x Equity beta = (1-.60) x 1.20 = 0.48

b. KA = 3% + 0.48 x 5% = 5.4%.

c. All-equity value = Free cash flows discounted at KA = $638.37 million.

d. Relevant cash flows are:

Year 1 2 3 4 5
Principal $320 $240 $160 $80 $0
Interest at 8% beginning balance 32 26 19 13 6
Tax shields (Tax rate x interest 13 10 8 5 3
expense)

PV of tax shields at KA = $34.04 million

e. Maximum acquisition price = $638.37 + $34.04 = $672.41 million.

f. The answer in “e” above ignores expected financial distress costs and is thus
surely an over-estimate of the top price the investors can justify paying.

18. See C8_Problem_18_Answer.xlsx on this Web site.

© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.