1.

Definitions Define the following terms:

a. Cost of debt.
b. Cost of equity.
c. After-tax WACC.
d. Equity beta.
e. Asset beta.
f. Pure-play comparable.
g. Certainty equivalent.

a. the expected return on debt; If the debt has very low default risk, this is close to its yield to maturity.
b. the expected return on equity
c. a weighted average of the cost of equity and the after-tax cost of debt, where the weights are the relative marke
d. the change in the return of the stock for each additional one percent change in the market return
e. the change in the return on a portfolio of all the firm’s securities (debt and equity) for each additional one perce
f. a company specializing in one activity that is similar to that of a division of a more diversified company
g. a certain cash flow occurring at Time t with the same present value as an uncertain cash flow at Time t
s yield to maturity.

weights are the relative market values of the firm’s debt and equity
e market return
for each additional one percent change in the market return
diversified company
n cash flow at Time t
True/false. True or false?
a. The company cost of capital is the correct discount rate for all projects because the high risks of some project
b. Distant cash flows are riskier than near-term cash flows. Therefore, long-term projects require higher risk-adj
c. Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff projects.

a. FALSE

b. FALSE

c. TRUE
e high risks of some projects are offset by the low risk of other projects.
ects require higher risk-adjusted discount rates.
ith quick-payoff projects.
Company cost of capital Quark Productions (“Give your loved one a quark today.”) uses its company cost of capital
or overestimate the value of high-risk projects?

Quark will over-estimate the value of high-risk projects (i.e. future cashflows will be discounted at a rate less than w
ses its company cost of capital to evaluate all projects. Will it underestimate

iscounted at a rate less than what is necessary).

 Company cost of capital The total market value of the common stock of the Okefenokee Real Estate Company is $6
treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is
Okefenokee debt is risk-free and the company does not pay tax.
a. What is the required return on Okefenokee stock?
b. Estimate the company cost of capital.
c. What is the discount rate for an expansion of the company’s present business?
d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleverage
on Okefenokee’s new venture.

Market value $ 6,000,000.00

Debt value $ 4,000,000.00
beta 1.5
risk premium 6%
risk free rate 4%

a. Required return 13.00% =C17+C15*C16

b. Cost of capital 9.40% =C14/(C14+C13)*C17+C13/(C13+C14)*C21

c.
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.

d. beta_new 1.2
Required return 11.200% =C17+C29*C16
Cost of capital 8.32% =C14/(C14+C13)*C17+C13/(C13+C14)*C30
Real Estate Company is $6 million, and the total value of its debt is $4 million. The
remium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity that

es. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return

oject is similar to the

ny cost of capital.
Company cost of capital You are given the following information for Golden Fleece Financial:

Long-term debt outstanding $ 300,000.00

Current yield to maturity (rdept) 8%
Number of shares of common stock $ 10,000.00
Price per share $ 50.00
Book value per share $ 25.00
Expected rate of return on stock (requity) 15%

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

Market value weights Required return

Debt $ 300,000.00 37.5% 8%
Equity $ 500,000.00 62.5% 15%

Cost of capital 12.38%

ce Financial:
 Company cost of capital Nero Violins has the following capital structure:

Total Market Value

Security Beta ($ millions)
Debt 0 $ 100
Preferred stock 0.2 $ 40
Common stock 1.2 $ 299

a. What is the firm’s asset beta? (Hint: What is the beta of a portfolio of all the firm’s securities?)
b. Assume that the CAPM is correct. What discount rate should Nero set for investments that expand the scale of it
interest rate of 5% and a market risk premium of 6%. Ignore taxes.

Total Market Value

Security Beta ($ millions) Weights
Debt 0 100 22.78%
Preferred stock 0.2 40 9.11%
Common stock 1.2 299 68.11%

a. Assets beta 0.8355353075

b. risk free rate 5%

risk premium 6%

r 10.01%
ecurities?)
ts that expand the scale of its operations without changing its asset beta? Assume a risk-free
WACC* A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is
is the after-tax WACC, assuming that the company pays tax at a 20% rate?

Weight Interest rate

risk free debt 40% 10%
Common stock 60% 14.00%

beta 0.5
market risk premium 8%
tax rate 20%

after-tax WACC 11.600%

e expected market risk premium is 8%, and the beta of the company’s common stock is .5. What
WACC Binomial Tree Farm’s financing includes $5 million of bank loans. Its common equity is shown in Binomial’s A
outstanding, which trade on the Wichita Stock Exchange at $18 per share. What debt ratio should Binomial use to c

Market value bank loans $ 5,000,000.00

Equity book value $ 6,670,000.00
Num shares 500,000.00
Price per share $ 18.00
Market value of equity $ 9,000,000.00

Debt ratio 35.71%

 ty is shown in Binomial’s Annual Report at $6.67 million. It has 500,000 shares of common stock
tio should Binomial use to calculate its WACC or asset beta? Explain.
Measuring risk Refer to the top-right panel of Figure 9.2. What proportion of U.S. Steel’s returns was explained by m
was diversifiable? How does the diversifiable risk show up in the plot? What is the range of possible errors in the es
 el’s returns was explained by market movements? What proportion of risk
nge of possible errors in the estimated beta?

a. R-squared measures the proportion of the total variance in the stock’s returns that
can be explained by market movements. U.S. Steel’s R2 shows that .15, or 15 percent
of variation was due to market movements;

b. the remainder, (1 –.15) = .85, or 85 percent, of the variation was diversifiable.

c.Diversifiable risk shows up in the scatter about the fitted line.

d.The standard error of the estimated beta was .93. If you said that the true beta
was 2 × .93 = 1.86 for either side of your estimate, you would have a 95 percent
chance of being right. The beta shown in the graph is 3.01.
Measuring risk Figure 9.4 shows plots of monthly rates of return on three stocks versus those of the market index.
given beside the plot.
a. Which stock is safest for a diversified investor?
b. Which stock is safest for an undiversified investor who puts all her money in one of these stocks?
c. Consider a portfolio with equal investments in each stock. What would be this portfolio’s beta?
d. Consider a well-diversified portfolio composed of stocks with the same beta and standard deviation as Ford. Wha
portfolio’s return? The standard deviation of the market portfolio’s return is 20%.
e. Use the capital asset pricing model to estimate the expected return on each stock. The risk-free rate is 4%, and th

a. A diversified investor would be safest to invest in the lowest market risk stock of Newmont, with β=0.10.

b. For the undiversified investor, the least risky option is IBM with a standard deviation of returns of 17.5%.

c Company beta weight

IBM 0.94 33.33%
Newmont 0.1 33.33%
Ford 1.26 33.33%

Portfolio beta 0.77

d. portfolio beta 1.26

market standard deviation 20%
portfolio standard deviati 25.2%

e. risk free rate 4%

Market risk premium 8%

expected return
IBM 11.52%
Newmont 4.80%
Ford 14.08%
hose of the market index. The beta and standard deviation of each stock is

ese stocks?
o’s beta?
ard deviation as Ford. What are the beta and standard deviation of this

e risk-free rate is 4%, and the market risk premium is 8%.

mont, with β=0.10.

f returns of 17.5%.
 Measuring risk The following table shows estimates of the risk of two well-known Canadian stocks:

Standard Deviation Standard

(%) R2 Beta Error of Beta
Sun Life Financial 18.7 0.12 0.86 0.3
Loblaw 19.5 0.06 0.63 0.33

a. What proportion of each stock’s risk was market risk, and what proportion was specific risk?
b. What is the variance of the returns for Sun Life Financial stock? What is the specific variance?
c. What is the confidence interval on Loblaw’s beta? (See page 234 for a definition of “confidence interval.”)
d. If the CAPM is correct, what is the expected return on Sun Life? Assume a risk-free interest rate of 5% and an ex
e. Suppose that next year, the market provides a 20% return. Knowing this, what return would you expect from Su

a. market risk 12.0%

specific risk 88.0%

market risk 6.0%

specific risk 94.0000%

b. variance 0.034969
Variance due to the market 0.00419628
Specific variance 0.03077272

c. 95% confidence intervalLoblaw’s = β ± 2(Std error of β)

Upper bound 1.29

Lower bound -0.03

d. risk free rate 5%

market return 12%
expected return on Sun Life 11.02%

e. risk free rate 5%

market return 20%
expected return on Sun Life 17.90%
 Canadian stocks:

specific risk?
cific variance?
n of “confidence interval.”)
ree interest rate of 5% and an expected market return of 12%.
return would you expect from Sun Life?
 Measuring risk Look again at Table 9.1. This time we will concentrate on Union Pacific.
a. Calculate Union Pacific’s cost of equity from the CAPM using its own beta estimate and the industry beta estimat
market risk premium of 7%.
b. Can you be confident that Union Pacific’s true beta is not the industry average?
c. Under what circumstances might you advise Union Pacific to calculate its cost of equity based on its own beta esti
d. You now discover that the estimated beta for Union Pacific in the period 2008–2012 was 1.3. Does this influence

a. risk free rate 2%

Market risk premium 7%
UP beta 0.9
Industry beta 1.25
Union Pacific’s cost of equity is 22.8 percent
R_own beta 8.30% firm’s beta rather than the in
R_industry beta 10.75%
difference -2.45%

b. difference 0.35
2 standard error interval length 0.44 0.44>0.35 No

c. Union Pacific’s beta might be different from the industry beta for a variety of reasons. For example, Union Pacific’s
typical firm in the industry. Or Union Pacific might have lower fixed operating costs so that its operating leverage is
less debt than is typical for the industry so that it has less financial leverage.

d. The large fluctuation in estimated beta lowers the confidence in the firm specific estimate for Union Specific. There
beta measure.
 the industry beta estimate. How different are your answers? Assume a risk-free rate of 2% and a

based on its own beta estimate?

as 1.3. Does this influence your answer to part (c)?

t of equity is 22.8 percent lower when based on the

m’s beta rather than the industry beta.

r example, Union Pacific’s business might be less cyclical than is the case for the
at its operating leverage is lower. Another possibility is that Union Pacific might have

e for Union Specific. Therefore, the cost might better be estimated using an industry
 Asset betas Which of these projects is likely to have the higher asset beta, other things equal? Why?
a. The sales force for project A is paid a fixed annual salary. Project B’s sales force is paid by commissions only.
b. Project C is a first-class-only airline. Project D is a well-established line of breakfast cereals.

a. Project A; a project with higher fixed costs generally has higher operating leverage, which leads to a higher beta

b. Project C; airline revenue is more cyclical than cereal revenue

gs equal? Why?
aid by commissions only.
cereals.

which leads to a higher beta

Asset betas EZCUBE Corp. is 50% financed with long-term bonds and 50% with common equity. The debt securities
beta is 1.25. What is EZCUBE’s asset beta?

weight beta
Bond 50% 0.15
Equity 50% 1.25

Asset beta 0.70

on equity. The debt securities have a beta of .15. The company’s equity
Asset betas What types of firms need to estimate industry asset betas? How would such a firm make the estima

Financial analysts or investors working with portfolios of firms may use industry betas. To calculate an industry
portfolio investments and evaluate how the returns generated by this portfolio relate to historical market move
uch a firm make the estimate? Describe the process step by step.

s. To calculate an industry beta we would construct a series of industry

to historical market movements.
Betas and operating leverage You run a perpetual encabulator machine, which generates revenues averaging $20 m
revenues. These costs are variable—they are always proportional to revenues. There are no other operating costs.
borrowing rate is 6%. Now you are approached by Studebaker Capital Corp., which proposes a fixed-price contract
10 years.
a. What happens to the operating leverage and business risk of the encabulator machine if you agree to this fixed-p
b. Calculate the present value of the encabulator machine with and without the fixed-price contract.

a. If you agree to the fixed price contract, operating leverage will increase. Changes in revenue w
changes in profit. Business risk as measured by beta_assets will also increase.

PV
b Revenue 20 222.2222
variable costs 50% 111.1111
fixed costs 10 $73.60
n 10 years
cost of capital 9%
borrowing rate 6%

With fixed cost contract

PV_Assets $101.69

Without fixed cost contract

PV_Assets $ 111.11
 evenues averaging $20 million per year. Raw material costs are 50% of
o other operating costs. The cost of capital is 9%. Your firm’s long-term
es a fixed-price contract to supply raw materials at $10 million per year for

you agree to this fixed-price contract?

contract.

hanges in revenue will result in greater than proportionate

se.
Diversifiable risk Many investment projects are exposed to diversifiable risks. What does “diversifiable” mean in th
accounted for in project valuation? Should they be ignored completely?

A diversifiable risk is unique to the project but has no effect on the risk of a well-diversified portfolio. If a risk is dive
for the project. However, any possibility of bad outcomes should be reflected in the project cash flows.
 oes “diversifiable” mean in this context? How should diversifiable risks be

sified portfolio. If a risk is diversifiable it does not affect the cost of capital
project cash flows.
Fudge factors John Barleycorn estimates his firm’s after-tax WACC at only 8%. Nevertheless, he sets a 15% compan
biases of project sponsors and to impose “discipline” on the capital budgeting process. Suppose Mr. Barleycorn is c
fact, optimistic by 7% on average. Explain why the increase in the discount rate from 8% to 15% will not offset the b

Suppose the expected cash flow in Year 1 is $100, but the project proposer provides an estimate of $100 × 115/108
percent gives the same result as discounting the true expected cash flow at 8 percent. Adjusting the discount rate,
does not do so for later cash flows, e.g., discounting a 2-year cash flow of $106.50 by 15 percent is not equivalent t
percent. By adjusting the discount rate, the project’s NPV will be less than it should be.
heless, he sets a 15% companywide discount rate to offset the optimistic
s. Suppose Mr. Barleycorn is correct about the project sponsors, who are, in
8% to 15% will not offset the bias.

an estimate of $100 × 115/108 = $106.50. Discounting this figure at 15

. Adjusting the discount rate, therefore, works for the first cash flow but it
15 percent is not equivalent to discounting a 2-year flow of $100 by 8
e.
 Fudge factors Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Ce
made one year hence after the shipment arrives by snow train. Unfortunately, there is a good chance of a coup d’é
Mom and Pop’s controller therefore decides to discount the payment at 40%rather than at the company’s 12% cos
a. What’s wrong with using a 40% rate to offset political risk?
b. How much is the $250,000 payment really worth if the odds of a coup d’état are 25%?

a. The threat of a coup d’état means that the expected cash flow is less than $250,000. The threat could also increase

b. cash flow probability

Pay 250,000.00 0.75
not pay 0 0.25

R 12%

Expecteed cash flow $ 187,500.00

PV $ 167,410.71
ries to the government of the Central Antarctic Republic. Payment of $250,000 will be
e is a good chance of a coup d’état, in which case the new government will not pay.
r than at the company’s 12% cost of capital.

25%?

0. The threat could also increase the discount rate, but only if it increases market risk.
Fudge factors An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% o
is still uncertainty about the amount of oil produced: 40% of new wells that strike oil produce only 1,000 barrels a d
a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $100 per barrel.
b. A geologist proposes to discount the cash flows of the new wells at 30% to offset the risk of dry holes. The oil com
sense? Briefly explain why or why not.

Dry holes 20%

Strikes oil 80%

if straikes oil then

daily production probability
1000 40%
5000 60%

Price $ 100.00

Daily production 2720

Annual cash revenue $ 99,280,000.00

b. The possibility of a dry hole is a diversifiable risk and should not affect the discount rate. This possibility affects f
rate for the project is the oil company’s normal cost of capital.
oducing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes oil, there
produce only 1,000 barrels a day; 60% produce 5,000 barrels per day.
e of $100 per barrel.
he risk of dry holes. The oil company’s normal cost of capital is 10%. Does this proposal make

rate. This possibility affects forecasted cash flows, as seen in part a. The appropriate discount
 Certainty equivalents A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. The interest rate is
the project has a beta of .5. If you use a constant risk-adjusted discount rate, what is
a. The PV of the project?
b. The certainty-equivalent cash flow in year 1 and year 2?
c. The ratio of the certainty-equivalent cash flows to the expected cash flows in years 1 and 2?

risk free rate 5%

Market risk premium 10%
Beta 0.5

R 10.0%

a. Year 1 2
Cash flow $ 110.00 $ 121.00
PV $ 100.00 $ 100.00 $ 200.00

b. Year 1 2
Certainity equivalent 105 110.25

c. Year 1 2
Ratio 0.95 0.91
 year 2. The interest rate is 5%, the estimated risk premium on the market is 10%, and

and 2?
 Certainty equivalents A project has the following forecasted cash flows:

C0 C1 C2 C3
-100 40 60 50

The estimated project beta is 1.5. The market return rm is 16%, and the risk-free rate rf is 7%.
a. Estimate the opportunity cost of capital and the project’s PV (using the same rate to discount each cash flow).
b. What are the certainty-equivalent cash flows in each year?
c. What is the ratio of the certainty-equivalent cash flow to the expected cash flow in each year?
d. Explain why this ratio declines.

Beta 1.5
Market return 16%
Risk free rate 7%

a. R 20.50%

C0 C1 C2 C3
Year 0 1 2 3
Cash flow -100 40 60 50
PV $ (100.00) $ 33.20 $ 41.32 $ 28.58 $ 3.09

b. Year 0 1 2 3
Certainity equivalent $ (100.00) $ 35.52 $ 47.31 $ 35.01

c. Year 0 1 2 3
Ratio 1.00 0.89 0.79 0.70

d. Using a constant risk-adjusted discount rate is equivalent to assuming that at decreases at a constant compounded
rate rf is 7%.
ate to discount each cash flow).

w in each year?

reases at a constant compounded rate.

Changing risk The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-mar
launch is not expected to produce any profits but should reveal consumer preferences. There is a 60% chance that
the scotch nationwide and will receive an expected annual profit of $700,000 in perpetuity. If demand is not satisfa
product will be subject to an average degree of risk, and therefore, McGregor requires a return of 12% on its invest
McGregor demands a return of 20% on this initial expenditure. What is the NPV of the diet scotch project?

Initial; investment time 0 $ (500,000.00)

launch 60% no launch 40%

Investment -5000000 Cash flows 0

Return 700000
R 12%

Project NPV at time 2 if launched 833333.333333

Project NPV at time 2 if no launched 0

NPV at time 0 $ (152,777.78)

oduct will first be test-marketed for two years in southern California at an initial cost of $500,000. This test
here is a 60% chance that demand will be satisfactory. In this case, McGregor will spend $5 million to launch
y. If demand is not satisfactory, diet scotch will be withdrawn. Once consumer preferences are known, the
eturn of 12% on its investment. However, the initial test-market phase is viewed as much riskier, and
t scotch project?
Beta of costs Suppose that you are valuing a future stream of high-risk (high-beta) cash outflows. High risk mea
discount rate, the less the present value. This seems to say that the higher the risk of cash outflows, the less you
Should the sign of the cash flow affect the appropriate discount rate? Explain.

It is correct that, for a high beta project, you should discount all cash flows at a high rate. Thus, the higher the ri
worry about them because the higher the discount rate, the closer the present value of these cash flows is to ze
have a series of payments that are high when the market is booming and low when it is slumping (i.e., a high be
The beta of an investment is independent of the sign of the cash flows. If an investment has a high beta for any
high beta for anyone receiving them. If the sign of the cash flows affected the discount rate, each asset would h
seller, which is clearly an impossible situation.
sh outflows. High risk means a high discount rate. But the higher the
cash outflows, the less you should worry about them! Can that be right?

ate. Thus, the higher the risk of the cash outflows, the less you should
of these cash flows is to zero. This result does make sense. It is better to
is slumping (i.e., a high beta) than the reverse.
ent has a high beta for anyone paying out the cash flows, it must have a
nt rate, each asset would have one value for the buyer and one for the
 Fudge factors An oil company executive is considering investing $10 million in one or both of two wells
million for 15 years. These are real (inflation-adjusted) cash flows. The beta for producing wells is .9. Th
two wells are intended to develop a previously discovered oil field. Unfortunately there is still a 20% ch
investment. Ignore taxes and make further assumptions as necessary.
a. What is the correct real discount rate for cash flows from developed wells?
b. The oil company executive proposes to add 20 percentage points to the real discount rate to offset t
c. What do you say the NPVs of the two wells are?
d. Is there any single fudge factor that could be added to the discount rate for developed wells that wo

Beta 0.9
Market risk premium 8%
Nominal risk free rate 6%
Inflation rate 4%
Investment $ 10,000,000.00

Well 1 Well 2
Cash flows $ 3,000,000.00 Cash flows
N 10 N
Prob of dry hole 20% Prob of dry hole

a. R_nominal 13.200%
R_real 8.85%

b. Discount rate 28.85%

NPV_Well1 $ (424,743.21)
NPV_Well2 $ (3,221,502.04)

c. Well 1 Well 2
Expected cash flows $ 2,400,000.00 $ 1,600,000.00

NPV_Well1 $ 5,507,230.30
NPV_Well2 $ 3,015,074.05

d. For Well 1, one can certainly find a discount rate (and hence a “fudge factor”) that, when applied to ca
2, one can find the appropriate discount rate. However, these two “fudge factors” will be different. Sp
distant cash flows, a smaller addition to the discount rate has a larger impact on present value.
million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2
beta for producing wells is .9. The market risk premium is 8%, the nominal risk-free interest rate is 6%, and expected inflation is 4%. The
fortunately there is still a 20% chance of a dry hole in each case. A dry hole means zero cash flows and a complete loss of the $10 million

d wells?
the real discount rate to offset the risk of a dry hole. Calculate the NPV of each well with this adjusted discount rate.

rate for developed wells that would yield the correct NPV for both wells? Explain.

$ 2,000,000.00
15
20%

factor”) that, when applied to cash flows of $3 million per year for 10 years, will yield the correct NPV of $5,504,600. Similarly, for Well
dge factors” will be different. Specifically, Well 2 will have a smaller “fudge factor” because its cash flows are more distant. With more
impact on present value.
 well 2 is expected to produce $2
and expected inflation is 4%. The
complete loss of the $10 million

iscount rate.

$5,504,600. Similarly, for Well

ws are more distant. With more