Managerial Finance-Week 11 Problem

Chapter 12 7. Portfolio Risk and Return. Suppose that the S&P 500, with a beta of 1.0, has an expected return of 10% and T-bills provide a risk-free return of 4%. (LO12-1) a. How would you construct a portfolio from these two assets with an expected return of 8%? Specifically, what will be the weights in the S&P 500 versus T-bills? b. How would you construct a portfolio from these two assets with a beta of .4? c. Find the risk premiums of the portfolios in parts (a) and (b), and show that they are proportional to their betas. 8. Portfolio Risk and Return. According to the CAPM, would the expected rate of return on a security with a beta less than zero be more or less than the risk-free interest rate? Why would investors invest in such a security? (Hint: Look back to the auto and gold example in Chapter 11.) (LO12-1) 9. Risk and Return. Suppose that the risk premium on stocks and other securities did, in fact, rise with total risk (i.e., the variability of returns) rather than just market risk. Explain how investors could exploit the situation to create portfolios with high expected rates of return but low levels of risk. (LO12-2) Chapter 13 15. Capital Structure. In 2018, Caterpillar Inc. had about 595 million shares outstanding. Their book value was $23.00 per share, and the market price was $154.80 per share. The company’s balance sheet shows that the company had $24.8 billion of long-term debt, which was currently selling near par value. (LO13-3) a. What was Caterpillar’s book debt-to-value ratio? b. What was its market debt-to-value ratio? c. Which of these two measures should you use to calculate the company’s cost of capital? 16. Capital Structure. Here is a simplified balance sheet for Epicure Pizza (figures in $ millions): Assets Liabilities and Shareholders’ Equity Current assets $ 80 Current liabilities $ 60 Fixed assets 125 Long-term debt 65 Equity 80 Total $205 Total $205 Note: There are 16 million shares outstanding. Epicure shares are currently priced at $12 each. (LO13-3) a. You wish to calculate Epicure’s WACC. What is the relevant figure for the company’s debt ratio? b. You now realize that since Epicure issued its debt, interest rates have fallen substantially. Do you need to revise your measure of the debt ratio upward or downward? 18. Cost of Debt. Olympic Sports has two issues of debt outstanding. One is a 9% coupon bond with a face value of $20 million, a maturity of 10 years, and a yield to maturity of 10%. The coupons are paid annually. The other bond issue has a maturity of 15 years, with coupons also paid annually, and a coupon rate of 10%. The face value of the issue is $25 million, and the issue sells for 94% of par value. The firm’s tax rate is 21%. (LO13-4) a. What is the before-tax cost of debt for Olympic? b. What is Olympic’s after-tax cost of debt? 19. Cost of Equity. Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 30%, and the current dividend yield is 2%. Its beta is 1.2, the market risk premium is 8%, and the risk-free rate is 4%. (LO13-4) a. Use the CAPM to estimate the firm’s cost of equity. b. Now use the constant growth model to estimate the cost of equity. c. Which of the two estimates is more reasonable? 20. Cost of Debt. Micro Spinoffs Inc. issued 20-year debt a year ago at par value with a coupon rate of 8%, paid annually. Today, the debt is selling at $1,050. If the firm’s tax bracket is 21%, what is its percentage cost of debt? (LO13-4)

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