Cost of Capital for Risks
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Chapter 13
7. Each of the six firms in the table below is expected to pay the listed dividend payment every year in perpetuity.
Firm Dividend ($million) Cost of capital (% /year)
S1 10 8
S2 10 12
S3 10 14
B1 100 8
B2 100 12
B3 100 14
a. Using the cost of capital in the table, calculate the market value of each firm.
b. Rank the three S firms by their market values and look at how their cost of capital is ordered. What would be the expected return for a self financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value? (the expected return of a self financing portfolio is the weighted average return of the consituent securities. Repeat using B firms.
c. Rank all six firms by their market values. How does this ranking order the cost of capital? What would be the expected return for a self financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value?
d. Repeat part ( c) but rank the firms by the dividend yield instead of the market value. What can you conclude about the dividend yield ranking compared to the market value ranking?
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The cost of capitals for risks are examined.
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Chapter 13
7. Each of the six firms in the table below is expected to pay the listed dividend payment every year in perpetuity.
Firm Dividend ($million) Cost of capital (% /year)
S1 10 8
S2 10 12
S3 10 14
B1 100 8
B2 100 12
B3 100 14
a. Using the cost of capital in the table, calculate the market value of each firm.
Market value of firm with constant dividend = D1/r
Firm Market Value
S1 =10/8%=$125 million
S2 =10/12%= $83.33 million
S3 =10/14%=$71.43 million
B1 =100/8%=$1250 million
B2 =100/12%=$833.33 million
B3 =100/14%=$714.3 ...
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