Worksheet #1

Risk, Return and Cost of Capital

Please do not attempt this worksheet without first reading chapters 12, 13 and 14 from RWJ. The
worksheet is designed to reinforce and supplement your learning on the aforementioned sections of the
textbook. Do your best in trying to complete this worksheet before the session but if you do not manage
then do not worry as I will provide a set of solutions to these questions at the end of the session. The
worksheet is really to keep you on your toes in learning the material and staying ahead of me!

1. Over long periods, investments in stocks have tended to outperform investments in bonds.
Nevertheless, there are a number of investors who in the long run only hold bond portfolios. Are
such investors irrational? No, stocks are riskier. Some investors are highly risk averse, and the
extra possible return doesn’t attract them relative to the extra risk.

2. What are the implications of the efficient market hypothesis for investors who trade stocks to
‘beat the market’? The EMH only says, that within the bounds of increasingly strong
assumptions about the information processing of investors, that assets are fairly priced. An
implication of this is that, on average, the typical market participant cannot earn excessive
profits from a particular trading strategy. However, that does not mean that a few particular
investors cannot outperform the market over a particular investment horizon. Certain investors
who do well for a period of time get a lot of attention from the financial press, but the scores of
investors who do not do well over the same period of time generally get considerably less
attention.

3. Why is some risk diversifiable and other nondiversifiable? Some of the risk in holding any asset
is unique to the asset in question. By investing in a variety of assets, this unsystematic portion of
the total risk can be eliminated at little cost. On the other hand, there are systematic risks that
affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated.
In other words, systematic risk can be controlled, but only by a costly reduction in expected
returns.

4. Which of the following news items might cause stocks prices in general to change and whether
they might cause Porto Corp.’s stock to change price:
- Government announces that inflation unexpectedly increased by 200 bpts;
systematic risk and will most likely cause prices to decline
- Porto Corp’s dividends met market analysts expectations; unsystematic risk and will
most likely cause the price to stay constant
- The Portuguese government announced an immediate change in the tax code to
increase the marginal corporate tax rate by 3%; systematic risk and will most likely
cause prices to stay the same
5. Is it possible that a risky asset could have a negative or zero beta? Explain. Based on the CAPM,
what is the expected return on such an asset? Yes. It is possible, in theory, to construct a zero
beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible
to have a negative beta; the return would be less than the risk-free rate. A negative beta asset
would carry a negative risk premium because of its value as a diversification instrument.

6. What are the advantages and disadvantages of using the SML approach to finding the cost of
equity capital? What specific pieces of information are needed to use this approach and where
might you get them from? Two primary advantages of the SML approach are that the model
explicitly incorporates the relevant risk of the stock, and the method is more widely applicable
than is the DGM model, since the SML doesn’t make any assumptions about the firm’s
dividends. The primary disadvantages of the SML method are (1) estimating three parameters:
the risk-free rate, the expected return on the market, and beta, and (2) the method essentially
uses historical information to estimate these parameters. The risk-free rate is usually estimated
to be the yield on very short maturity T-bills and is hence observable; the market risk premium is
usually estimated from historical risk premiums and is not directly observable. The stock beta,
which is unobservable, is usually estimated either by determining some average historical beta
from the firm and the market’s return data, or using beta estimates provided by analysts and
investment firms.

7. How do you determine the cost of debt for a company? Does it matter whether the debt is
public or private? How might you estimate the cost of debt for a private firm? The appropriate
aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue
new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the
company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm
could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar
risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming
the firm’s private debt is rated), or (3) consulting analysts and investment bankers. Even if the
debt is publicly traded, an additional complication is when the firm has more than one issue
outstanding; these issues rarely have the same yield because no two issues are ever completely
homogeneous.

8. When might it be appropriate to use a single cost of capital for all the projects of a firm? What
are the limitations to this approach? What alternatives do you have available to you? If the
different operating divisions were in much different risk classes, then separate cost of capital
figures should be used for the different divisions; the use of a single, overall cost of capital
would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to
receive funds for investment projects, since their return would exceed the hurdle rate despite
the fact that they may actually plot below the SML and hence be unprofitable projects on a risk-
adjusted basis. The typical problem encountered in estimating the cost of capital for a division is
that it rarely has its own securities traded on the market, so it is difficult to observe the market’s
valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for
 the division, or to use subjective adjustments of the overall firm hurdle rate based on the
perceived risk of the division.

9. Suppose you bought a 7% coupon bond one year ago for $1,040. If the bond has a face value of
$1,000 and sells for $1,070 today, then: (a) Compute the dollar return on the investment over
the past year? (b) Compute the nominal rate of return on the investment over the past year? (c)
If inflation last year was 4%, what was your total rate of return on the investment?

The total dollar return is the increase in price plus the coupon payment, so:
Total dollar return = $1,070 – 1,040 + 70 = $100
The total percentage return of the bond is:
R = [($1,070 – 1,040) + 70] / $1,040 = .0962 or 9.62%
Notice here that we could have simply used the total dollar return of $100 in the
numerator of this equation.
Using the Fisher equation, the real return was:
(1 + R) = (1 + r)(1 + h)
r = (1.0962 / 1.04) – 1 = .0540 or 5.40%

10. You observe the following returns on a stock over the past 5 years: 7%, -12%, 11%, 38%, and
14%. (a) What is the arithmetic and geometric return over the 5 year period? (b) What was the
variance and standard deviation over the 5 year period? (c) If the average rate of inflation was
3.5% and the average T-bill rate was 4.2% over the 5 year period, then what was the average
real return on the stock over the 5 year period and what was the average nominal risk
premium?

a. To find the average return, we sum all the returns and divide by the number of returns, so:
Average return = (.07 –.12 +.11 +.38 +.14)/5 = .1160 or 11.60%
b. Using the equation to calculate variance, we find:
Variance = 1/4[(.07 – .116)2 + (–.12 – .116)2 + (.11 – .116)2 + (.38 – .116)2 + (.14 – .116)2]
Variance = 0.032030
So, the standard deviation is: Standard deviation = (0.03230)1/2 = 0.1790 or 17.90%

11. If returns from holding small-company stocks are normally distributed, what is the appropriate
probability that your money will double in value in one year? What about triple in value?

The mean return for small company stocks was 17.1 percent, with a standard deviation of 32.6
percent. Doubling your money is a 100% return, so if the return distribution is normal, we can
use the z-statistic. So:
z = (X – µ)/
z = (100% – 17.1)/32.6% = 2.543 standard deviations above the mean
This corresponds to a probability of 0.55%, or once every 200 years. Tripling your money
would be:
z = (200% – 17.1)/32.6% = 5.610 standard deviations above the mean.
This corresponds to a probability of about .000001%, or about once every 1 million years.
12. Over 40 years, an asset delivered an arithmetic return of 15.3% and geometric return of 11.9%.
Using Blume’s formula, what is your best estimate of the future annual returns over 5, 10 and 20
years, respectively?

To find the best forecast, we apply Blume’s formula as follows:

5 -1 40 - 5
R(5) = × 11.9% + × 15.3% = 14.95%
39 39

10 - 1 40 - 10
R(10) = × 11.9% + × 15.3% = 14.52%
39 39

20 - 1 40 - 20
R(20) = × 11.9% + × 15.3% = 13.64%
39 39

13. Use the following information

State of Economy Probability of Rate of Return if State Occurs
State of Economy Stock X Stock Y Stock Z
Boom 0.15 0.30 0.45 0.33
Good 0.45 0.12 0.10 0.15
Poor 0.35 0.01 -0.15 -0.05
Bust 0.05 -0.06 -0.30 -0.09
If your portfolio is invested 40 percent in Stock Y and 30% each in Stocks X and Z, what is the
expected rate of return and variance (and SD) of the portfolio?

a. This portfolio does not have an equal weight in each asset. We first need to find the return of
the portfolio in each state of the economy. To do this, we will multiply the return of each asset
by its portfolio weight and then sum the products to get the portfolio return in each state of
the economy. Doing so, we get:

Boom: E(Rp) = .30(.3) + .40(.45) + .30(.33) = .3690 or 36.90%

Good: E(Rp) = .30(.12) + .40(.10) + .30(.15) = .1210 or 12.10%
Poor: E(Rp) = .30(.01) + .40(–.15) + .30(–.05) = –.0720 or –7.20%
Bust: E(Rp) = .30(–.06) + .40(–.30) + .30(–.09) = –.1650 or –16.50%

And the expected return of the portfolio is:

E(Rp) = .15(.3690) + .45(.1210) + .35(–.0720) + .05(–.1650) = .0764 or 7.64%

b. To calculate the standard deviation, we first need to calculate the variance. To find the
variance, we find the squared deviations from the expected return. We then multiply each
possible squared deviation by its probability, than add all of these up. The result is the
variance. So, the variance and standard deviation of the portfolio is:

p
2
= .15(.3690 – .0764)2 + .45(.1210 – .0764)2 + .35(–.0720 – .0764)2 + .05(–.1650 – .0764)2
 2
p = .02436

p = (.02436)1/2 = .1561 or 15.61%

14. You own a portfolio equally invested in a risk free asset and two stocks. If one stock has a beta
of 1.38 and the total portfolio is equally as risky as the market, what must be the beta of the
other stock in your portfolio?

The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. If the
portfolio is as risky as the market it must have the same beta as the market. Since the beta of
the market is one, we know the beta of our portfolio is one. We also need to remember that the
beta of the risk-free asset is zero. It has to be zero since the asset has no risk. Setting up the
equation for the beta of our portfolio, we get:
1 1 1
p = 1.0 = /3(0) + /3(1.38) + /3( X)
Solving for the beta of Stock X, we get:
X = 1.62

15. A stock has an expected return of 10.2%, the risk-free rate is 4.5%, and the market risk premium
is 8.5%. What is the beta of the stock?

We are given the values for the CAPM except for the of the stock. We need to substitute these
values into the CAPM, and solve for the of the stock. One important thing we need to realize is
that we are given the market risk premium. The market risk premium is the expected return of
the market minus the risk-free rate. We must be careful not to use this value as the expected
return of the market. Using the CAPM, we find:
E(Ri) = .102 = .045+ .085 i
i = 0.67

16. A stock has a beta of 1.35 and an expected and an expected return of 16%. A risk free asset
yields 4.8%. What is the expected return on a portfolio that is equally in in the two assets? If a
portfolio comprising the two assets has a beta of 0.95, what are the portfolio weights?

a. Again we have a special case where the portfolio is equally weighted, so we can sum the
returns of each asset and divide by the number of assets. The expected return of the portfolio
is:
E(Rp) = (.16 + .048)/2 = .1040 or 10.40%
b. We need to find the portfolio weights that result in a portfolio with a of 0.95. We know the
of the risk-free asset is zero. We also know the weight of the risk-free asset is one minus the
weight of the stock since the portfolio weights must sum to one, or 100 percent. So:
p = 0.95 = wS(1.35) + (1 – wS)(0)
0.95 = 1.35wS + 0 – 0wS
wS = 0.95/1.35
wS = .7037
And, the weight of the risk-free asset is:
wRf = 1 – .7037 = .2963
17. You have $100,000 to invest in a portfolio containing stock P and stock Q. Your aim is to create a
portfolio that has an expected return of 18.5%. If stock P has an expected return of 17.2% and a
beta of 1.4, and stock Q has an expected return of 13.6% and a beta of 0.95, how much money
will you invest in stock Q? What is the beta of your portfolio?

18. Using the following information

State of Economy Probability of Rate of Return if State Occurs
State of Economy Stock X Stock Y
Bust 0.15 -0.08 -0.05
Normal 0.70 0.13 0.14
Boom 0.15 0.48 0.29
Compute the expected return on each stock. Assuming that the CAPM holds and Stock X’s beta
is greater than Stock Y’s beta by 0.25. What is the expected market risk premium?

19. Stock in UPBS has a beta of 0.85. The market risk premium is 8% and T-bills currently yield 5%.
The company’s most recent dividend was $1.60 per share, and the dividends are expected to
grow at a rate of 6% forever. If the stock sells for $37 today, what is your estimate on the
company’s cost of equity?

We have the information available to calculate the cost of equity using the CAPM and the
dividend growth model. Using the CAPM, we find:
RE = .05 + 0.85(.08) = .1180 or 11.80%
And using the dividend growth model, the cost of equity is
RE = [$1.60(1.06)/$37] + .06 = .1058 or 10.58%
Both estimates of the cost of equity seem reasonable. If we remember the historical return on
large capitalization stocks, the estimate from the CAPM model is about two percent higher than
average, and the estimate from the dividend growth model is about one percent higher than the
historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we
will use the average of the two, so:
RE = (.1180 + .1058)/2 = .1119 or 11.19%

20. FCP issued a 30-year, 8% semiannual bond 7 years ago. The bond currently sells for 95 percent
of its face value. The marginal tax rate for FCP is 35%. What is the pre-tax and post-tax cost of
debt?

a. The pretax cost of debt is the YTM of the company’s bonds, so:
P0 = $950 = $40(PVIFAR%,46) + $1,000(PVIFR%,46)
R = 4.249%
YTM = 2 × 4.249% = 8.50%
b. The aftertax cost of debt is:
RD = .0850(1 – .35) = .0552 or 5.52%
c. The after-tax rate is more relevant because that is the actual cost to the company.
21. Andres Madrid Sports has a weighted average cost of capital of 8.9%. The company’s cost of
equity is 12%, and its pretax cost of debt is 7.9%. The tax rate is 35%. What is the company’s
target debt-to-equity ratio?

Here we have the WACC and need to find the debt-equity ratio of the company. Setting up the
WACC equation, we find:
WACC = .0890 = .12(E/V) + .079(D/V)(1 – .35)
Rearranging the equation, we find:
.0890(V/E) = .12 + .079(.65)(D/E)
Now we must realize that the V/E is just the equity multiplier, which is equal to:
V/E = 1 + D/E
0.0890(D/E + 1) = .12 + .05135(D/E)
Now we can solve for D/E as:
.06765(D/E) = .031
D/E = .8234

22. Compute the WACC for Hulk Enterprises given the following information and assuming a tax rate
of 35%. Debt: 8,000 6.5% coupon bonds outstanding with $1,000 face value, 20 years to
maturity, selling for 92 percent of par, the bonds make semiannual payments. Common stock:
250,000 shares outstanding, selling for $57 per share, and the beta of the stock is 1.05.
Preferred stock: 15,000 shares of 5 percent preferred stock outstanding, currently selling for $93
per share. The market risk premium is 8% and the risk-free rate is 4.5%.

We will begin by finding the market value of each type of financing. We find:

MVD = 8,000($1,000)(0.92) = $7,360,000

MVE = 250,000($57) = $14,250,000
MVP = 15,000($93) = $1,395,000
And the total market value of the firm is:
V = $7,360,000 + 14,250,000 + 1,395,000 = $23,005,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:
RE = .045 + 1.05(.08) = .1290 or 12.90%
The cost of debt is the YTM of the bonds, so:
P0 = $920 = $32.50(PVIFAR%,40) + $1,000(PVIFR%,40)
R = 3.632%
YTM = 3.632% × 2 = 7.26%
And the aftertax cost of debt is:
RD = (1 – .35)(.0726) = .0472 or 4.72%
The cost of preferred stock is:
RP = $5/$93 = .0538 or 5.38%
Now we have all of the components to calculate the WACC. The WACC is:
WACC = .0472(7.36/23.005) + .1290(14.25/23.005) + .0538(1.395/23.005) = .0983 or 9.83%
Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the aftertax
cost of debt in the equation, so the term is not needed here.
23. Nuno Fashions is considering a project that will result in initial aftertax cash savings of $2.7
million at the end of the first year, and these savings will grow at a rate of 4% per year forever.
The firm has a target debt-equity ratio of 0.90, a cost of equity of 13%, and an aftertax cost of
debt of 4.8%. The cost saving proposal is somewhat riskier than the usual project the firm
undertakes; management uses the subjective approach and applies an adjustment factor of +2%
to the cost of capital for such risky projects. Under what circumstances should the company take
on the project?

Using the debt-equity ratio to calculate the WACC, we find:

WACC = (.90/1.90)(.048) + (1/1.90)(.13) = .0912 or 9.12%
Since the project is riskier than the company, we need to adjust the project discount rate for the
additional risk. Using the subjective risk factor given, we find:
Project discount rate = 9.12% + 2.00% = 11.12%
We would accept the project if the NPV is positive. The NPV is the PV of the cash outflows plus
the PV of the cash inflows. Since we have the costs, we just need to find the PV of inflows. The
cash inflows are a growing perpetuity. If you remember, the equation for the PV of a growing
perpetuity is the same as the dividend growth equation, so:
PV of future CF = $2,700,000/(.1112 – .04) = $37,943,787
The project should only be undertaken if its cost is less than $37,943,787 since costs less than
this amount will result in a positive NPV.

24. Lisandro Corp. has a debt-equity ratio of 1.20. The company is considering a new plant that will
cost $145 million to build. When the company issues new equity, it incurs a flotation cost of 8%.
The flotation cost on new debt is 3.5%. What is the initial cost of the plant if the company raises
all equity externally? What is it uses 60% retained earnings? What is all equity investment is
financed through retained earnings?

We can use the debt-equity ratio to calculate the weights of equity and debt. The weight of debt
in the capital structure is:

wD = 1.20 / 2.20 = .5455 or 54.55%

And the weight of equity is:
wE = 1 – .5455 = .4545 or 45.45%

Now we can calculate the weighted average floatation costs for the various percentages of
internally raised equity. To find the portion of equity floatation costs, we can multiply the equity
costs by the percentage of equity raised externally, which is one minus the percentage raised
internally. So, if the company raises all equity externally, the floatation costs are:

fT = (0.4545)(.08)(1 – 0) + (0.5455)(.035)
fT = .0555 or 5.55%

The initial cash outflow for the project needs to be adjusted for the floatation costs. To account
for the floatation costs:

Amount raised(1 – .0555) = $145,000,000

Amount raised = $145,000,000/(1 – .0555)
Amount raised = $153,512,993

If the company uses 60 percent internally generated equity, the floatation cost is:

fT = (0.4545)(.08)(1 – 0.60) + (0.5455)(.035)

fT = .0336 or 3.36%
And the initial cash flow will be:

Amount raised(1 – .0336) = $145,000,000

Amount raised = $145,000,000/(1 – .0336)
Amount raised = $150,047,037

If the company uses 100 percent internally generated equity, the floatation cost is:

fT = (0.4545)(.08)(1 – 1) + (0.5455)(.035)
fT = .0191 or 1.91%
And the initial cash flow will be:

Amount raised(1 – .0191) = $145,000,000

Amount raised = $145,000,000/(1 – .0191)
Amount raised = $147,822,057