Given the following returns on Stock J and “the market” during the last three years, what is the

beta
coefficient of Stock J?

Year Stock J Market

1 -13.85% -8.63%
2 22.90 12.37
3 35.15 19.37

Rise/Run = (Y1 – Y0)/(X1 – X0) = (JYear 2 – JYear 1)/(MYear 2 – MYear 1)

= (22.90% – (-13.85%))/(12.37% – (-8.63%)) = 36.75%/21.0%
beta = 1.75.
Given the following returns on Stock Q and “the market” during the last three years, what is the difference
in the calculated beta coefficient of Stock Q when Year 1-Year 2 data are used as compared to
Year 2-Year 3 data?

Year Stock Q Market

1 6.30% 6.10%
2 -3.70 12.90
3 21.71 16.20

Year 1–Year 2 data:

Rise/Run = (Y1 – Y0)/(X1 – X2)
= (-3.7% – 6.30%)/(12.90% – 6.10%) = -10.0%/6.8%
beta = -1.47.

Year 2 – Year 3 data:

beta = (21.71% – (-3.70%))/(16.20% – 12.90%) = 25.41%/3.3% = 7.70.

Difference:
betaY2 – Y3 – betaY1 – Y2 = 7.70 – (-1.47) = 9.17.
Stock X

k = kRF + (kM - kRF)bp

14% = 6% + 6%bp
8% = 6%b
bp = 1.333.

bp = 0.6(bX) + 0.4(bY)
1.333 = 0.6(0.9484) + 0.4bY
0.7643 = 0.4bY
bY = 1.9107 = 1.91.
Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of
inflation in the future. The real risk-free rate is equal to 3 percent and the market risk premium is
5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last
5 years.

kRF = k* + IP = 3% + 5% = 8%.
ks = 8% + (5%)2.0 = 18%.
Consider the following information for three stocks, Stock A, Stock B, and Stock C. The returns on each of
the three stocks are positively correlated, but they are not perfectly correlated. (That is, all of the correlation
coefficients are between 0 and 1.)

Expected Standard
Stock Return Deviation Beta
Stock A 10% 20% 1.0
Stock B 10 20 1.0
Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested in Stock B. Portfolio Q has
one third of its funds invested in each of the three stocks. The risk-free rate is 5 percent, and the
market is in equilibrium. (That is, required returns equal expected returns.) What is the market
risk premium (kM - kRF)?
Using Stock A (or any stock),
10% = kRF + (kM – kRF)bA
10% = 5% + (kM – kRF)1.0
(kM – kRF) = 5%.
A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5
percent. What is the market risk premium?

12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043%  6.30%.
Company X has a beta of 1.6, while Company Y’s beta is 0.7. The risk-free rate is 7 percent, and the
required rate of return on an average stock is 12 percent. Now the expected rate of inflation built into kRF
rises by 1 percentage point, the real risk-free rate remains constant, the required return on the market
rises to 14 percent, and betas remain constant. After all of these changes have been reflected in the data,
by how much will the required return on Stock X exceed that on Stock Y?

bX = 1.6; bY = 0.7; kRF = 7%; kM = 12%.

Inflation increases by 1%, but k* remains constant. kRF increases by 1%; kM rises to 14%.

Before inflation change:

kX = 7% + 5%(1.6) = 15%.
kY = 7% + 5%(0.7) = 10.5%.

After inflation change:

kX = 8% + (14% - 8%)1.6 = 17.6%.
kY = 8% + (14% - 8%)0.7 = 12.2%.

kX - kY = 17.6% - 12.2% = 5.4%.

You hold a diversified portfolio consisting of a $10,000 investment in each of 20 different common stocks
(that is, your total investment is $200,000). The portfolio beta is equal to 1.2. You have decided to sell
one of your stocks that has a beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase
another stock that has a beta equal to 1.4. What will be the beta of the new portfolio?

1.2 = 1/20(0.7) + (19/20)b

b is average beta for other 19 stocks.
1.165 = (19/20)b.
New Beta = 1.165 + 1/20(1.4) = 1.235.
An investor is forming a portfolio by investing P50,000 in stock A that has a beta of 1.50, and P25,000 in
stock B that has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a
yield of 4 percent. What is the required rate of return on the investor’s portfolio?

(P50,000/P75,000)1.5 + (P25,000/P75,000)0.9 = 1.3. The required rate of return is then simply:

4% + (6% - 4%)1.3 = 6.6%.
Bridges & Associates’

What is the expected price of the stock today?

First, we must find the explicit forecasted dividends:
D1 = 0.75
D2 = 0.9375 (0.75  1.25 = 0.9375)
D3 = 1.265625 (0.9375  1.35 = 1.265625)
D4 = 1.3415625 (1.265625  1.06 = 1.3415625)

Now, we need to determine the terminal value of the stock in Year 3, using the Year 4 dividend:

P̂3 = D4/(ks – g)
P̂3 = P1.3415625/(0.10 - 0.06)
P̂3 = P33.5390625.

$0.75 $0.9375 ($1.265625  $33.5390625

P0 = + +
1.10 (1.10)2 (1.10)3
= P0.6818 + P0.7748 + P26.1493
= P27.6059  P27.61.
What is the expected price of the stock 10 years from today?
In 10 years, this stock will be a constant growth stock. Therefore, use the constant growth formula
and find the price in Year 10. In order to find the value in Year 10, determine the dividend in Year 11:
D11 = 0.75  1.25  1.35  (1.06)8 = P2.0172.

Now, calculate the stock price in Year 10:

P̂10 = D11/(ks – g)
P̂10 = P2.0172/(0.10 - 0.06)
P̂10 = P50.43.

Alternatively, you could have taken the terminal value P̂3 calculated in the previous question and used
the constant growth rate to find P̂10 :
P̂10 = P̂3  (1 + g)7
P̂10 = P33.5391  (1.06)7
P̂10 = P50.43.
Rangan Co.

Free cash flow

What is the company’s free cash flow the first year (t = 1)?
FCF1 = EBIT(1 - T) + Depreciation – ΔNOWC – Capital expenditures
= P500,000,000 - P300,000,000 = P200,000,000.

FCF model for valuing stock

Using the free cash flow model, what is the intrinsic value of the company’s stock today?
Using the FCF model, P̂3 = FĈF3 (1.07)/(0.11 – 0.07) = [(P750 - P500) (1.07)]/0.04 = P6,687.50, which
is the value of the firm at t = 3 after the dividend is received.

So, the value of the firm today = P200/(1.11) + P200/(1.11)2 + (P250 + P6,687.50)/(1.11)3 =
P5,415.1449 million  P5,415 million.

This is the value of the total firm (debt, preferred stock, and equity), so the value of debt and preferred
stock must be deducted to arrive at the value of the firm’s common equity. The common equity has
a value of P5,415 million – P700 million = P4,715 million. So, the price/share = P4,715 million/100
million = P47.15.
Xavier

What is the stock’s intrinsic value today? (That is, what is P̂0 ?)
P̂4 = D4(1 + g)/(ks – g) = P1.75(1.06)/(0.13 – 0.06) = P26.50.

P̂0 = P1.75/1.13 + P1.75/(1.13)2 + P1.75/(1.13)3 + (P1.75 + P26.50)/(1.13)4

P̂0 = P1.5487 + P1.3705 + P1.2128 + P17.3263
P̂0 = P21.4583  P21.46.

Assume that the forecasted dividends and the required return are the same one year from now, as those
forecasted today. What is the expected intrinsic value of the stock one year from now, just after the dividend
has been paid at t = 1? (That is, what is P̂1 ?)
P̂1 = P1.75/1.13 + P1.75/(1.13)2 + (P1.75 + P26.50)/(1.13)3
P̂1 = P1.5487 + P1.3705 + P19.5787
P̂1 = P22.4979  P22.50.
Nahanni Treasures

D0 (1.06) $1.00(1.06)
P0, Old = = = P16.06.
0.126 - 0.06 0.066
$1.00(1 + gNew) $1.00(1.065) $1.065
P0, New = = = = P15.21.
k̂s, New - gNew 0.135 - 0.065 0.07
Change in price = P15.21 – P16.06 = -P0.85.
The probability distribution for kM for the coming year is as follows:

Probability kM
0.05 7%
0.30 8
0.30 9
0.30 10
0.05 12

If kRF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and D0 =
P2, what market price gives the investor a return consistent with the stock’s risk?
Calculate required return on market and stock:
kM = 0.05(7%) + 0.30(8%) + 0.30(9%) + 0.30(10%) + 0.05(12%) = 9.05%.
ks = 6.05% + (9.05% - 6.05%)2.0 = 12.05%.

Calculate expected equilibrium stock price:

$2(1.07)
P̂0   $42.38.
0.1205  0.07
 Material Supplies

$2
ks(old) = + 0.05 = 0.10.
$40
0.10 = kRF + (RPM)bOld = 0.06 + (0.02)bOld; bOld = 2.00.
Calculate new required return and beta:
$2.00
Note that D0 = = P1.90476.
1.05
D1,New = P1.90476(1.105) = P2.10476.
2.10476
ks(New) = + 0.105 = 0.1752.
$30
2.10476
ks(New) = + 0.105 = 0.1752.
$30
Cali

Step 1: Set up an income statement to find net income:

Sales P100,000 P10 x10,000
Variable costs 50,000 P5 x 10,000
Fixed costs 10,000 (Given)
EBIT P 40,000
Interest 1,200 0.08 x P15,000
EBT P 38,800
Taxes 15,520 0.40 x P38,800
NI P 23,280

Then, calculate the total amount of dividends, Div = Net income Payout = P23,280
0.6 = P13,968.

Dividends/Share = Total dividend/# of shares outstanding

= P13,968/10,000 = P1.3968.

Note: Because these projections are for the coming year, this dividend is D1, or the
dividend for the coming year.
Step 2: Use the CAPM equation to find the required return on the stock:
kS = kRF + (kM - kRF)b = 0.05 + (0.09 - 0.05)1.4 = 0.106 = 10.6%.

Step 3: Calculate stock price:

P0 = D1/(kS - g)
= P1.3968/(0.106 - 0.08)
= P53.72.
Carlson

Step 1: Calculate ks, the required rate of return:

$2
ks = + 6% = 10% + 6% = 16%.
$20

Step 2: Calculate kRF, the risk-free rate:

16% = kRF + (15% - kRF)1.2
16% = kRF - 1.2kRF + 18%
0.2kRF = 2%
kRF = 10%.

Step 3: Calculate the new stock price and capital gain:

New ks = 10% + (15% - 10%)0.6 = 13%.
$2
P̂New = = P28.57.
0.13 - 0.06
Therefore, the percentage capital gain is 43% calculated as follows:
$28.57 - $20.00 $8.57
= = 0.4285  43%.
$20.00 $20.00
Time line:
0 gks == 40%
9%
1 g2 = 25%
2 gn = 5%
3 Years
1
| | | |
2.00 2.80 3.50 3.675
P0 = ? 3.675
P̂2 = = 91.875
0.09  0.05
CFt 0 2.80 95.375

ks = Dividend yield + g = 0.04 + 0.05 + 0.09  9%.

Numerical solution:
$2.80 $95.375
P0    $82.84.
1.09 (1.09)2
Holmgren Hotels

P84.80
Global

Cost of retained earnings

What is Global’s cost of retained earnings if it can use retained earnings rather than issue new common stock?

$0.90(1.05)
ks = + 0.05 = 0.1600 = 16.00%.
$8.59
Cost of external equity
What is the cost of common equity raised by selling new stock?

$0.90(1.05)
ke = + 0.05 = 0.1722 = 17.22%.
$8.59(1 - 0.10)

WACC
What is the firm’s weighted average cost of capital if the firm has sufficient retained earnings to fund the equity
portion of its capital budget?

Since the firm can fund the equity portion of its capital budget with retained earnings, use ks in
WACC.
WACC = wdkd(1 - T) + wcks
= 0.3(0.12)(1 - 0.4) + 0.7(0.16)
= 0.0216 + 0.112
= 0.1336 = 13.36%.
Byron

Cost of external equity

What is the component cost of the equity raised by selling new common stock?

$2.00(1.05)
ke = + 0.05 = 17%.
$21.88(1 - 0.2)

WACC
What is the firm’s weighted average cost of capital?

WACC = 0.4(0.14)(1 - 0.4) + 0.6(0.17) = 0.1356 = 13.56%  13.6%.

Rollins

Cost of debt
What is Rollins’ component cost of debt?

Time line:
0 kd/2 = ? 1 2 3 4 40 6-month
| | | | | • • • | Periods
PMT = 60 60 60 60 60
VB = 1,000 FV = 1,000

Since the bond sells at par of P1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-
tax cost of debt to Rollins is 12.0 percent. The after-tax cost of debt equals:
kd,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1000; PMT = 60; FV = 1000;
Output: I = 6.0% = kd/2.
kd = 6.0% 2 = 12%.
kd(1 - T) = 12.0%(0.6) = 7.2%.
Cost of preferred stock
What is Rollins’ cost of preferred stock?

Cost of preferred stock: kp = P12/P100(0.95) = 12.6%.

Cost of equity: CAPM

What is Rollins’ cost of retained earnings using the CAPM approach?

Cost of retained earnings (CAPM approach):

ks = 10% + (5%)1.2 = 16.0%.

Cost of equity: DCF

What is the firm’s cost of retained earnings using the DCF approach?

Cost of retained earnings (DCF approach):

$2.00(1.08)
ks = + 8% = 16.0%.
$27

Cost of equity: risk premium

What is Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium approach?

Cost of retained earnings (bond yield-plus-risk-premium approach):

ks = 12.0% + 4.0% = 16.0%.

WACC
What is Rollins’ WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital
budget?

$2.00(1.08)
Calculate ke: ke = + 8% = 16.89%.
$27(1  0.1)

WACC = wdkd(1 - T) + wpkp + wcke

= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.89%) = 14.09 14.1%.
Jackson

Stock price--constant growth

How much should an investor be willing to pay for this stock today?

ks = 10% + (4%)1.5 = 16%.

$3.00(1.10)
P0 = = P55.00.
0.16 - 0.10

Cost of external equity

What will be Jackson’s cost of new common stock if it issues new stock in the marketplace today?

Cost of new common equity:

$3.30
ke = + 0.10 = 16.32%.
$55.00(0.95)