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    Cost of capital, Capital Budgeting

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    8-16
    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?

    9-15
    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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    Solution Preview

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    8.16
    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?

    First, calculate the return on the market portfolio

    CAPM (Capital Asset Pricing Model) equation is:
    r A= r f + βA (r m - r f) or rm = (ra-rf) / βA + rf

    risk free rate= r f = 5.25%
    beta of asset= βA= 1.25
    return on market portfolio= r m = to be determined
    required return on asset= r A = 12.00%
    Plugging in the values
    r m = 10.65% =(12.%-5.25%)/1.25+5.25%

    Then calculate the beta of total investment

    Beta of the total portfolio is the weighted average of beta of components

    Beta of old investment= 1.25
    Beta of new investment= 0.75

    Amount weights
    Old investment 5,000,000 0.91 =5000000 / 5500000
    New Investment 500,000 0.09 =500000 / 5500000
    Total investment 5,500,000

    Therefore, Beta of total investment = 1.205 =0.91 x 1.25 + 0.09 x 0.75

    Now calculate the required return on total investment

    CAPM (Capital Asset Pricing Model) equation is:
    r A= r f + βA (r m - r f)

    risk free rate= r f = 5.25%
    beta of asset= βA= 1.205
    return on market portfolio= r m = 10.65%
    required return on asset= r A = to be determined
    Plugging in the ...

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