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Cost of Capital for Risks

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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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 ...

Solution Summary

The cost of capitals for risks are examined.

$2.19