Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
12th Edition
ISBN: 9781259144387
Author: Richard A Brealey, Stewart C Myers, Franklin Allen
Publisher: McGraw-Hill Education
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Chapter 9, Problem 12PS
Company cost of capital Nero Violins has the following capital structure:
- 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 its operations without changing its asset beta? Assume a risk-free interest rate of 5% and a market risk premium of 6%. Ignore taxes.
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If a firm cannot invest retained earnings to earn a rate of returngreater than or equal to the required rate of return on retained earnings, it should return those funds to its stockholders.
The cost of equity using the CAPM approach
The current risk-free rate of return (rRFrRF) is 4.67% while the market risk premium is 5.75%. The Burris Company has a beta of 0.78. Using the capital asset pricing model (CAPM) approach, Burris’s cost of equity is .
The cost of equity using the bond yield plus risk premium approach
The Taylor Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Taylor’s bonds yield 11.52%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 3.55%. Based on the bond-yield-plus-risk-premium approach, Taylor’s cost of internal equity is:
18.84%
15.07%
14.32%
18.08%
The…
Show your work for the following
A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)
Multiple Choice
A) 0.7
B) 0
C) 1.0
D) 1.2
Answer the following a) When will the different DCF methods use the same discount rate? b) The cost of debt (ka) will change as the capital structure of a firm changes. Why or
why not? c) Why does the cost of equity (k.) increase as the amount of debt in the capital structure of a firm increases? Why? d) Freebie Inc.'s common stock has a beta of 1.3. If
the risk-free rate is 4.5% and the expected return on the market is 12%, what is its cost of equity capital? e) Why do branded food companies command the highest EBIT
multiple (about 8) and transportation companies the lowest (about 3)? f) Should a firm use its cost of capital as a hurdle/discount rate to value all internal divisions? Why or why
not? g) An option can have more than one source of value. Consider a mining company. The company can mine for ores today or wait another year (or more) to mine. What real
options can you identify here? h) Do you consider dividend payments by the firm in calculating cash flows? Why or why not? i)…
Chapter 9 Solutions
Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Ch. 9 - (VAR.P and STDEV.P) Choose two well-known stocks...Ch. 9 - (AVERAGE, VAR.P and STDEV.P) Now calculate the...Ch. 9 - (SLOPE) Download the Standard Poors index for the...Ch. 9 - Company cost of capital Suppose a firm uses its...Ch. 9 - Prob. 2PSCh. 9 - Definitions Define the following terms: a. Cost of...Ch. 9 - Asset betas EZCUBE Corp. is 50% financed with...Ch. 9 - Prob. 6PSCh. 9 - Fudge factors John Barleycorn estimates his firms...Ch. 9 - Asset betas Which of these projects is likely to...
Ch. 9 - True/false True or false? a. The company cost of...Ch. 9 - Certainty equivalents A project has a forecasted...Ch. 9 - Company cost of capital The total market value of...Ch. 9 - Company cost of capital Nero Violins has the...Ch. 9 - Measuring risk The following table shows estimates...Ch. 9 - Company cost of capital You are given the...Ch. 9 - Measuring risk Look again at Table 9.1. This time...Ch. 9 - Prob. 16PSCh. 9 - WACC Binomial Tree Farms financing includes 5...Ch. 9 - Prob. 18PSCh. 9 - Prob. 19PSCh. 9 - Prob. 20PSCh. 9 - Certainty equivalents A project has the following...Ch. 9 - Prob. 22PSCh. 9 - Beta of costs Suppose that you are valuing a...Ch. 9 - Fudge factors An oil company executive is...
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- True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. False True The cost of equity using the CAPM approach The current risk-free rate of return (rRFrRF) is 4.23% while the market risk premium is 6.63%. The Allen Company has a beta of 0.78. Using the capital asset pricing model (CAPM) approach, Allen’s cost of equity is (9.40%, 8.46, 11.28, 9.87) . The cost of equity using the bond yield plus risk premium approach The Hoover Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Hoover’s bonds yield 10.28%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 3.55%. Based on the bond-yield-plus-risk-premium approach, Hoover’s cost of internal equity is: 13.83%…arrow_forwardTrue or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. False True The cost of equity using the CAPM approach The current risk-free rate of return (TRF) is 3.86% while the market risk premium is 6.63%. The Monroe Company has a beta of 0.92. Using the capital asset pricing model (CAPM) approach, Monroe's cost of equity is The cost of equity using the bond yield plus risk premium approach The Lincoln Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Lincoln's bonds yield 11.52%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Lincoln's cost of internal equity is: 19.76% 16.47% 15.65% O 18.12%arrow_forwardYou have the following information about Burgundy Basins, a sink manufacturer. Equity shares outstanding Stock price per share Yield to maturity on debt Book value of interest-bearing debt Coupon interest rate on debt Market value of debt Book value of equity Cost of equity capital Tax rate a. What is the internal rate of return on the investment? Note: Round your answer to 2 decimal places. Internal rate of return I Weighted-average cost Burgundy is contemplating what for the company is an average-risk investment costing $38 million and promising an annual ATCF of $4.9 million in perpetuity. % b. What is Burgundy's weighted-average cost of capital? Note: Round your answer to 2 decimal places. 20 million % $39 7.5% $350 million 4.4% $ 245 million $ 410 million 11.8% 35%arrow_forward
- Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because a. as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will increase b. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets c. returns below the cost of capital will cover all the fixed costs associated with capital and provide excess returns to the firm's stockholdersarrow_forwardThe cost of retained earnings True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. True False The cost of equity using the CAPM approach The current risk-free rate of return (rRF ) is 4.23% while the market risk premium is 6.17%. The D’Amico Company has a beta of 1.56. Using the capital asset pricing model (CAPM) approach, D’Amico’s cost of equity is . The cost of equity using the bond yield plus risk premium approach The Kennedy Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Kennedy’s bonds yield 10.28%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Kennedy’s cost of internal equity is:…arrow_forwardTrue or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. True False The cost of equity using the CAPM approach The current risk-free rate of return (rRFrRF) is 4.23% while the market risk premium is 6.17%. The Burris Company has a beta of 0.78. Using the capital asset pricing model (CAPM) approach, Burris’s cost of equity is . The cost of equity using the bond yield plus risk premium approach The Jackson Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Jackson’s bonds yield 10.28%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 3.55%. Based on the bond-yield-plus-risk-premium approach, Jackson’s cost of internal equity is: 13.83% 16.60% 13.14%…arrow_forward
- The cost of raising capital through retained eamings is the cost of raising capital through issuing new common stock. The cost of equity using the CAPM approach The current risk-free rate of return (rRF) is 4.23 % , while the market risk premium is 6.63 %. the D'Amico Company has a beta of 0.78. Using the Capital Asset Pricing Model (CAPM) approach, D'Amico's cost of equity is The cost of equity using the bond yield plus risk premium approach The Hoover Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Hoover's bonds yield 11.52%, and the fim's analysts estimate that the firm's risk premium on its stock over its bonds is 3.55 %. Based on the bond-yield-plus-risk-premium approach, Hoover's cost of internal equity is: 18.08% 14.32% 15.07% 18.84% The cost of equity using the discounted cashflow (or dividend growth) approach Kirby Enterprises's stock is currently selling for $32.45…arrow_forward6. Company cost of capital (S9.2) Nero Violins has the following capital structure: Total Market Value ($ millions) $100 Security Debt Preferred stock Common stock Beta 0 0.20 1.20 40 299 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 its operations without changing its asset beta? Assume a risk-free interest rate of 5% and a market risk premium of 6%. Ignore taxes.arrow_forwardTotal investment risk can be broken down into two types of risk. What are these two types of risk and which should NOT affect expected return? (b) A firm has a beta of 1.3. The expected market return is 12% and the risk-free rate is 2%. What should be the firm's equity cost of capital? Use CAPMarrow_forward
- Which of the following statements is true? A. Companies look for investments with payback periods that are larger than their maximum accepted payback period B. An investment with a profatibility index less than 1 is profitable and desirable OC. A projected is accepted if the IRR is less than the cost of capital O D. None of the above are truearrow_forwardHh2.arrow_forwardWyden Brothers uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company’s WACC? a) A reduction in the market risk premium. b) An increase in the risk-free interest rate. c) An increase in the beta of the company’s stock. d) An increase in expected inflation. e) An increase in the flotation costs associated with issuing preferred stock.arrow_forward
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