Question 1

Distinguish among beta (or market) risk, within-firm (or corporate) risk, and standalone risk for a
project being considered for inclusion in the capital budget. Of the three measures, which is
theoretically the most relevant and why?

Question 2
Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are
reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk
projects?

Question 3
How should a manager determine the capital structure weights that are used to calculate the
WACC?

Question 4
Assume that there is an increase in the risk-free rate. What impact would this increase have on
the cost of debt? What impact would this have on the cost of equity?

Question 5
What are the likely effects of a policy in which a company fails to adjust for differences in risk
when estimating the cost of capital for their various projects?

Question 6
ECRI Corporation is a holding company with four main subsidiaries. The percentage of its
business coming from each of the subsidiaries, and their respective betas, are as follows:

SUBSIDIARY PERCENTAGE OF BUSINESS BETA

Electric utility 60% 0.70

Cable company 25% 0.90
Real estate 10% 1.30
International/special projects 5% 1.50

Required

a. What is the holding company’s beta?

b. Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What
is the holding company’s required rate of return?

c. ECRI is considering a change in its strategic focus; it will reduce its reliance on the
electric utility subsidiary, so the percentage of its business from this subsidiary will be 50
percent. At the same time, ECRI will increase its reliance on the international/ special
projects division, so the percentage of its business from that subsidiary will rise to 15
percent. What will be the shareholders’ required rate of return if ECRI adopts these
changes?
Question 7
An individual has $35,000 invested in a stock that has a beta of 0.8 and $40,000 invested in a
stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her
portfolio’s beta?

Question 8
Suppose you hold a diversified portfolio consisting of a $7,500 investment in each of 20 different
common stocks. The portfolio beta is equal to 1.12. Now, suppose you have decided to sell one
of the stocks in your portfolio with a beta equal to 1.0 for $7,500 and to use these proceeds to
buy another stock for your portfolio. Assume the new stock’s beta is equal to 1.75. Calculate
your portfolio’s new beta.

Question 9
Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be
optimal:
Debt 25%
Preferred stock 15%
Common equity 60%
100%

LEI’s expected net income this year is $34,285.72, its established dividend payout ratio is 30
percent, its federal-plus-state tax rate is 40 percent, and investors expect earnings and dividends
to grow at a constant rate of 9 percent in the future. LEI paid a dividend of $3.60 per share last
year, and its stock currently sells at a price of $54 per share.

LEI can obtain new capital in the following ways:

Preferred: New preferred stock with a dividend of $11 can be sold to the public at a price of $95
per share.

Debt: Debt can be sold at an interest rate of 12 percent.

Required

a. Determine the cost of each capital structure component.

b. Calculate the weighted average cost of capital.

c. LEI has the following investment opportunities that are typical average-risk projects for
the firm:
PROJECT COST AT t = 0 RATE OF RETURN
A $10,000 17.4%
B 20,000 16.0
C 10,000 14.2
D 20,000 13.7
E 10,000 12.0

Which projects should LEI accept? Why?

Question 10
Percy Motors has a target capital structure of 40 percent debt and 60 percent equity. The yield to
maturity on the company’s outstanding bonds is 9 percent, and the company’s tax rate is 40
percent. Percy’s CFO has calculated the company’s WACC as 9.96 percent. What is the
company’s cost of common equity?

Question 11
The Patrick Company’s cost of common equity is 16 percent. Its before-tax cost of debt is 13
percent, and its marginal tax rate is 40 percent. The stock sells at book value. Using the
following balance sheet, calculate Patrick’s after-tax weighted average cost of capital:

ASSETS LIABILITIES AND EQUITY

Cash $ 120 Long-term debt $1,152

Accounts receivable 240 Equity 1,728
Inventories 360
Plant and equipment, net 2,160

Total assets $2,880 Total liabilities and equity $2,880

Question 12
Goodtread Rubber Company has two divisions: the tire division, which manufactures tires for
new autos, and the recap division, which manufactures recapping materials that are sold to
independent tire recapping shops throughout the United States. Since auto manufacturing
fluctuates with the general economy, the tire division’s earnings contribution to Goodtread’s
stockprice is highly correlated with returns on most other stocks. If the tire division were
operated as a separate company, its beta coefficient would be about 1.50. The sales and profits of
the recap division, on the other hand, tend to be countercyclical, because recap sales boom when
people cannot afford to buy new tires. The recap division’s beta is estimated to be 0.5.
Approximately 75 percent of Goodtread’s corporate assets are invested in the tire division and 25
percent are invested in the recap division. Currently, the rate of interest on Treasury securities is
9 percent, and the expected rate of return on an average share of stock is 13 percent. Goodtread
uses only common equity capital, so it has no debt outstanding.
Required

a. What is the new corporate beta?

b. What is the required rate of return on Goodtread’s stock?

c. What is the cost of capital for projects in each division?

Question 13
Bradford Manufacturing Company has a beta of 1.45, while Farley Industries has a beta of .85.
The required return on an index fund that holds the entire stock market is 12%. The risk free rate
of interest is 5%.

Required
a. By how much does Bradford required rate of return exceed Farley’s required return?

b. Given a similar average annual cash flows of 500,000 generated by both firms till infinity,
which firm valuation will be most affected by the cost of capital

Question 14
Ziege Systems is considering the following independent projects for the coming year:

Project Required Investment Rate of Return Risk

A 4 million 14% High
B 5 million 11.5 High
C 3 million 9.5 Low
D 2 million 9 Average
E 6 million 12.5 High
F 5 million 12.5 Average
G 6 million 7 Low
H 3 million 11.5 Low

Ziege’s WACC is 10% but it adjusts for risk by adding 2% to the WACC for high- risk projects
and subtracting 2% for low-risk projects.

a. Which projects should Ziege accept if it faces no capital constraints?

b. If Ziege can only invest a total of 13 million, which projects should it accept and what
would be the dollar size of the capital budget?

c. Suppose Ziege can raise additional funds beyond the 13 million, but each new increment
(or partial increment) of 5 million of new capital will cause the WACC to increase by
1%. Assuming that Ziege uses the same methods of risk adjustment, which projects
should it now accept and what would be the dollar size of its capital budget?
Question 15
The risk free rate of return is 7% and the annual risk premium received on shares over Treasury
bills has been 5%. A firm is considering the following investments (the CAPM applies):

Project Beta Expected Return (%)

1 .6 10
2 .9 11
3 1.3 20
4 1.7 21

Required

a. Which project should be accepted?

b. Why doesn’t the firm use its overall discount rate of 13% for all project appraisal?

Question 16
The staff of Heymann Manufacturing has estimated the following net cash flows and
probabilities for a new manufacturing process:

Net Cash Flows

Year Probability = 0.2 Probability = 0.6 Probability = 0.2
0 (100,000) (100,000) (100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 20,000 30,000 40,000
5* 0 20,000 30,000

Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and Line 5*
contains the estimated salvage values. Heymann’s cost of capital for an average risk project is 10
percent.

Required

a. Assume that the project has average risk. Find the project’s expected NPV.

b. Find the best-case and worst-case NPVs.

c. Assume that all the cash flows are perfectly positively correlated, that is, there are only
three possible cash flow streams over time: (1) the worst case, (2) the most likely, or base,
case, and (3) the best case, with probabilities of 0.2, 0.6, and 0.2, respectively. These cases
are represented by each of the columns in the table. Find the expected NPV, its standard
deviation, and its coefficient of variation.
d. The coefficient of variation of Heymann’s average project is in the range 0.8 to 1.0. If the
coefficient of variation of a project being evaluated is greater than 1.0, 2 percentage points
are added to the firm’s cost of capital. Similarly, if the coefficient of variation is less than
0.8, 1 percentage point is deducted from the cost of capital. What is the project’s cost of
capital? Should Heymann accept or reject the project?

Question 17
Huang Industries is considering a proposed project for its capital budget. The company estimates
that the project’s NPV is $12 million. This estimate assumes that the economy and market
conditions will be average over the next few years. The company’s CFO, however, forecasts that
there is only a 50 percent chance that the economy will be average. Recognizing this uncertainty,
she has also performed the following scenario analysis:

Economic Scenario Probability of Outcome NPV

Recession .05 (70 million)
Below Average .20 (25 million)
Average .50 12 million
Above Average .20 20 million
Boom .05 30 million

Required
What is the project’s expected NPV, its standard deviation, and its coefficient of variation?

Question 18
The Butler-Perkins Company (BPC) must decide between two mutually exclusive investment
projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows
from each project begin 1 year after the initial investment is made and have the following
probability distributions:

Project A Project B
Probability Net Cash Flows Probability Net Cash Flows
.2 6,000 .2 0
.6 6,750 .6 6,750
.2 7,500 .2 18,000

BPC has decided to evaluate the riskier project at a 12 percent rate and the less risky project at a
10 percent rate.

Required
 a. What is the expected value of the annual net cash flows from each project? What is the
coefficient of variation (CV)?

b. What is the risk-adjusted NPV of each project?

c. If it were known that Project B’s cash flows were negatively correlated with other cash
flows of the firm whereas Project A’s cash flows were positively correlated, how would
this knowledge affect the decision? If Project B’s cash flows were negatively correlated
with gross domestic product (GDP), would that influence your assessment of its risk?

Question 19
Cashion International is considering a project that is susceptible to risk. An initial investment of
90,000 will be followed by three years each with the following most likely cash flows (there is
no tax or inflation):

$ $
Annual sales (volume of 100,000 units multiplied 200,000
by estimated sales price of $2)
Annual costs:
Labor 100,000
Materials 40,000
Other 10,000
150,000 (150,000)
50,000

The initial investment consists of 70,000 in machines, which have a zero scrap value at the end
of the three- year life of the project and 20,000 in additional working capital which is
recoverable at the end. The discount rate is 10 percent.

Required
Perform a sensitivity analysis showing the sensitivity of NPV to changes in the sales price, labor
costs, material costs and discount rate

Question 20
A company is trying to decide whether to make a 400,000 investment in a new product area. The
project will last 10 years and the 400,000 of the machinery will have a zero scrap value. Other
best estimate forecasts are:

- Sales volume of 22,000 units per year

- Sales price of $21 per unit
- Variable direct costs $16 per unit

There are no other costs and inflation and tax are not relevant
Required

a. The senior management team has asked you to calculate the internal rate of return (IRR)
of this project based on these estimated.

b. To gain a broader picture they also want you to recalculate IRR on the assumption that
each of the following variables changes adversely by 5 percent in turn:

- Sales volume
- Sales price
- Variable direct costs

Question 21
Toughnut plc is considering a two-year project that has the following probability distribution of
returns:

Year 1 Year 2
Return $ Probability Return $ Probability
8,000 .1 4,000 .3
10,000 .6 8,000 .7
12,000 .3

The events in each year are independent of other years (that is, there are no conditional
probabilities). An outlay of 15,000 is payable at Time 0 and other cash flows are receivable at
the year ends. The risk-adjusted discount rate is 11 percent.

Calculate

a. The expected NPV

b. The standard deviation of NPV

Question 22
A project with an initial outlay of $1 million has a 0.2 probability of producing a return of
$800,000 in year 1 and a 0.8 probability of delivering a return of $500,000 in year1. If the
$800,000 result occurs then the second year could return either $700,000 (probability of 0.5) or
$300,000 (probability of 0.5). If the $500,000 result for year 1 occurs then either $600,000
(probability 0.7) or $400,000 (probability 0.3) could be received in the second year. All cash
flows occur on anniversary dates. The discount rate is 12 percent.

Required
Calculate the expected return and standard deviation.
Question 23
A project requires an immediate outflow of cash of 400,000 in return for the following probable
cash flows:

State of Economy Probability End of Year 1 End of Year 2

($) ($)
Recession 0.3 100,000 150,000
Growth 0.5 300,000 350,000
Boom 0.2 500,000 550,000

Assume that the state of the economy will be the same in the second year as in the first year. The
required rate of return is 8%. There is no tax or inflation.

Required
a. Calculate the expected NPV

b. Calculate the standard deviation of NPV.

Question 24
John Inc. is attempting to select the best of three mutually exclusive projects, a, b and c.
Although all the projects have 5-year lives, they possess different degrees of risk. Project a is in
class V, the highest risk class; project b is in class II, the below average risk class; and project c
is in class III, the average risk class. The basic cash flow data for each project and the risk
classes and risk-adjusted discount rates (RADRs) used by the firm are shown in the following
tables.
Project a Project b Project c
Initial ($180,000) ($235,000) ($310,000)
Investment (CF0)
Year (t) Cash Inflows (CFt)
1 $80,000 $50,000 $90,000
2 70,000 60,0000 90,000
3 60,000 70,000 90,000
4 60,000 80,000 90,000
5 60,000 90,000 90,000
 Risk Classes and RADRs
Risk Class Description Risk Adjusted Discount Rate
(RADR)
I Lowest risk 10%
II Below-average 13
risk
III Average risk 15
IV Above-average 19
risk
V Highest risk 22

Required
a. Find the risk adjusted NPV for each project using RADR.

b. Which project , if any would you recommend that the firm undertake.