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Capital Budgeting and Portfolio Beta

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e. Suppose you are managing a stock portfolio consisting a mixture of high and low beta
stocks. You have information which leads you to believe that the stock market is likely to
be very strong in the immediate future, i.e., you are confident that the market is about to
rise sharply. If you want to take advantage of the situation to maximize the value of your
portfolio, what would you do now? Explain your answer.

a) Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Does this mean Project X has a shorter payback than Project Y? Explain your answer.

i) In capital budgeting, why is the focus on cash flows rather than net income? Should interest payments be considered in capital budgeting? How about the changes in net operating working capital? Provide the arguments to support your answers.

1- What would be the effect if a company increases its debt ratio, but leaves its operating
income (EBIT) and total assets unchanged?

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The explanations and two examples are included in the attached file.

e. Suppose you are managing a stock portfolio consisting a mixture of high and low beta
stocks. You have information which leads you to believe that the stock market is likely to
be very strong in the immediate future, i.e., you are confident that the market is about to
rise sharply. If you want to take advantage of the situation to maximize the value of your
portfolio, what would you do now? Explain your answer.
Let us assume that stock A is low beta stocks (beta of 0.6) and stock B is high beta stocks (beta of 1.4). The portfolio in scenario 1 consists of 50% of each type of stocks.
Scenario 1: Portfolio beta on a two-asset portfolio bP = w1*b1 + w2*b2 = 1 (that is, equal to market beta)
Scenario 2: Portfolio beta on a two-asset portfolio bP = w1*b1 + w2*b2 = 1.4 (that is, equal to market beta)
Scenario 1
Weight Beta w*b
Stock A 50% 0.6 0.3
Stock B 50% 1.4 0.7
Portfolio beta 1.0

Scenario 2
Weight Beta w*b
Stock A 0% 0.6 0
Stock B 100% 1.4 1.4
Portfolio beta 1.4

The portfolio in scenario 2 consists of only type B stocks, with a higher beta. Note that the portfolio beta increases ...

Solution Summary

This solution includes explanations in capital budgeting. First, the beta of a two-asset portfolio is computed and a possible reallocation is suggested based on change in market conditions. Second, the internal rate of return (IRR) is discussed with its relationship to the net present value (NPV) and the payback period. Third, the relationship of NPV and its relationship with net income, interest payments, and net operating working capital (NOWC) are being discussed concisely. Finally, the effect of changes in debt ratio are discussed. The solution includes two clarifying examples.

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Financial management: required return, beta, terminal value, WACC, project selection

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You have been managing a 5 million portfolio that has a beta of 1.25 and a required rate of return of 12%. the current risk free rate is 5.25%. assume that you receive another 500,000. If you invest the money in a stock with a beta of 0.75, what will be the required return on your 5.5 million portfolio?

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Dozier Corporation is a fast growing supplier of office products. Analysts project the following free cash flows (FCFs) during the enxt 3 years, after which FCF is expected to grow to a constant 7% rate. Dozier's WACC is 13%.

Year: 0=NA Year 1= -20Millon Year 2= 30 Million Year 3= 40 Million

a. What is Dozier's terminal, or horizon, value? (hint. find the value of all free cash flows beyond year 3 discounted back to year 3)?
b. What is the firms value today?
c. Suppose dozier has 100 Million of debt and 10 Million shares of stock outstanding. What is your estimate of the current price per share?

10-9
The Patrick company's cost of common equity is 16%, its before tax cost of debtr is 13%, and its marginal tax rate is 40%. The stock sells at book value. using the following balance sheet, calculate Patricks WACC.

Assets:
cash=120
acct receivables=240
inventories=360
plant and equip net=2,160
total assets=2,880

Liabilities and Equity
long-term debt=1,152
common equity=1,728
total liabilities and equity=2,880

10-12
WACC. Midwest electric company MEC uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd=10% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2, its expected constant growth rate is 4%, and its common stock sells for $20. MEC tx rate is 40%. Two projects are available: Project A has a rate of return of 13%, while Project B's return is 10%. These two projects are equallly risky and about as risky as the firms existing needs.

a. What is the cost of common equity?
b. What is the WACC?
c. Which Project should Midwest accept?

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