FINC 409 Homework 8

Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.8, 1.0, 1.5, and 1.7, respectively. Assume all current and future projects will be financed with 50 debt and 50 equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 6%) is 14% and the after-tax yield on the company's bonds is 7%. What will the WACCs be for each division?

According to CAPM, the implied market risk premium = (14% - 6%)/1.0 = 8% Cost of Equity for Each Division Division A 6% + 0.8 x 8% = 12.4% Division B 6% + 1.0 x 8% = 14% Division C 6% + 1.5 x 8% = 18% Division D 6% + 1.7 x 8% = 19.6% WACC for Each Decision (with 50% debt and 50% equity, 10% after-tax cost of debt) Division A 50% x 7% + 50% x 12.4% = 9.7 Division B 50% x 7% + 50% x 14% = 10.5% Division C 50% x 7% + 50% x 18% = 12.5% Division D 50% x 7% + 50% x 19.6% = 13.3%

JaiLai Cos. stock has a beta of 0.7, the current risk-free rate is 5.7%, and the expected return on the market is 12%. What is JaiLai's cost of equity?

Answer: 10.11% Risk Free Rate + Beta x (Market Return - Risk Free Rate) = Cost Of Equity 5.7% + 0.7 x (12% - 5.7%) = 10.11%

Suppose that JB Cos. has a capital structure of 76% equity, 24% debt, and that its before-tax cost of debt is 14% while its cost of equity is 18%. Assume the appropriate weighted-average tax rate is 25%.

Answer: 16.2% After Tax Cost Of Debt = Cost of Debt x (1-Tax Rate) 14% x (1-.25) = 10.5% Cost of Equity = 18% WACC = Weight Of Equity x Cost Of Equity + Weight Of Debt x After Tax Cost Of Debt .76 x 18% + .24 x 10.5% = 16.2%

The average annual return on the S&P 500 Index from 1996 to 2005 was 20.36%. The average annual T-bill yield during the same period was 3.36%. What was the market risk premium during these ten years?

Answer: 17% Index - Yield = Market Risk Premium 20.36 - 3.36 = 17

Netflix, Inc. has a beta of 3.73. If the market return is expected to be 8.50% and the risk-free rate is 1.50%, what is Netflix's risk premium?

Answer: 26.11% Beta x (Market Return - Risk Free Return) = Risk Premium 3.73 x (8.50% - 1.50%) = 26.11%

If the risk-free rate is 3.40% and the risk premium is 4.4%, what is the required return?

Answer: 7.8% Risk free rate + Risk premium - Required return 3.4 + 4.4 = 7.8

What is a measure of an asset's riskiness?

Answer: Beta

Stock A has a beta of -0.2, whereas stock B has a beta of 0.1. Which one of the two stocks would you expect to provide a higher return?

Answer: Stock B

Increasing the debt of the firm decreases the cast taxes owed.

Answer: True

Company XYZ has a target capital structure of 30% equity and 70% debt. Its cost of equity is 10%, and cost of debt is 5%. What would happen to XYZ's WACC if its capital structure were to shift to 40% equity and 60% debt?

Answer: WACC Increases