Problem_Set__8_Checkpoints

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Southern New Hampshire University *

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401

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Finance

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Jan 9, 2024

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docx

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2

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Fin 401 Problem Set #8 Checkpoints Firm Cost of Capital Note: These checkpoints are short answers intended to help you check your work as you go along. They are not full solutions, which will be posted on Learning Suite after the problem set is turned in. Remember that to get full credit for problem sets you must show all your work, and the answers listed here are usually not sufficient responses to the questions. 1. The annual returns for stock A have a standard deviation of 40%, and the stock’s beta is 1.2. The annual returns for stock B have a standard deviation of 60%, and the stock’s beta is 0.9. Which stock would have a higher expected return? Why? 2. ABC Corporation has an asset beta of 0.7. The risk-free rate is 4%, and the market risk premium is 6%. a. What is the required return on ABC Corporation’s assets? 8.2% b. You find online that ABC has market leverage (D/V) of 40% and an equity beta of 1.0. What must ABC’s debt beta be? What is the required return on debt? The required return on equity? Bd = 0.25 c. Suppose instead of the information in part b, you find that ABC has market leverage (D/V) of 60% and an equity beta of 1.25. At this leverage, what would their debt beta be? What is the required return on debt? The required return on equity? d. Suppose, instead, that you find ABC has no debt at all. What would their equity beta be? The required return on equity? 3. Each year Briggs & Stratton (producer of gasoline engines) estimates its own company- wide cost of capital. For the most recent year, it based its calculation on the following data (info taken from Keown, et al, Financial Management, p. 394): Risk-free rate comes from the current 30-year government bond yield = 6.1% Market Risk Premium comes from the historical average difference between equity returns and long-term bonds returns = 6%
Equity Beta is estimated by a regression of B&S stock returns on S&P 500 returns = 0.83 Cost of debt comes from the yield to maturity on the company’s bonds = 7.5% Capital structure is based on target debt to total market value ratio (D/V) = 23% Based on Briggs & Stratton’s assumptions, what is their required return on assets? Solve for Ra using both the asset beta approach and by averaging the cost of debt and cost of equity. Ra = 10.3% 4. Caterpillar currently has an equity beta of 1.5. Their market cap is $70 billion, and they have $30 billion in debt. Suppose that the yield to maturity on their bonds is 3%. Further assume that the risk-free rate is 2% and the market risk premium is 6%. Solve for the required return on assets using both the asset beta approach and by averaging the cost of debt and cost of equity. 8.60% 2
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