AcF 214 Tutorial Week 6.

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Presentation transcript:

AcF 214 Tutorial Week 6

Q1. The stock of Cumbrian Industries (CI) has a current market value of £100 million and a beta of 1.5. The firm also has £100 million of outstanding riskless debt. CI decides to reduce its debt by £50 million by issuing new equity. Calculate the asset beta of Cumbrian Industries as well as its new equity beta following the change in its capital structure. You want to estimate the asset beta of CI given its original equity beta of 1.5 and the ratio of E/V is 0.5 (=£100m/(£100m+£100m)) In the special case in which debt is riskless (and therefore has a beta of zero), the CI asset beta is given by

Now, one can estimate Cumbrian Industries equity beta following the change in the capital structure. The new E/V ratio is (£100+£50)/£200 = 0.75. Consequently,

Q2. You need to estimate the equity cost of capital for XYZ Corp Q2. You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns: a. (10% – 45%)/2 = -17.5% b. Excess returns: MKT 3%, –38% XYZ 7%, –46% Beta = (7 – (–46))/(3 – (–38)) = 1.29 c. Alpha E[Rs-rf] – beta  (E[Rm -rf]) = Alpha (7%-46%)/2 – 1.29  (3%-38%)/2 = 3.1% d. E[R] = 3% + 1.29  (8% - 3%) = 9.45% e. Use (d) – CAPM is more reliable than average past returns, which would imply a negative cost of capital in this case! Ignore (c), as alpha is not persistent.

Project beta = 0.85 (using all equity comp) Q3. Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an all-equity firm that specializes in this business. Suppose Harburtin’s equity beta is 0.85, the risk-free rate is 4%, and the market risk premium is 5%. If your firm’s project is all equity financed, estimate its cost of capital. Project beta = 0.85 (using all equity comp) Thus, rp = 4% + 0.85(5%) = 8.25%

Q4. Consider the setting of Problem 3 Q4. Consider the setting of Problem 3. You decided to look for other comparables to reduce estimation error in your cost of capital estimate. You find a second firm, Thurbinar Design, which is also engaged in a similar line of business. Thurbinar has a stock price of $20 per share, with 15 million shares outstanding. It also has $100 million in outstanding debt, with a yield on the debt of 4.5%. Thurbinar’s equity beta is 1.00. a. E = 20  15 = 300; E+D = 400; Bu = 300/400  1.00 + 100/400  0 = 0.75; Ru = 4% + .75(5%) = 7.75% b. Re = 4% + 1.0  5% = 9%; Ru = 300/400  9% + 100/400  4.5% = 7.875% c. In the first case, we assumed the debt had a beta of zero, so rd = rf = 4%; In the second case, we assumed rd = ytm = 4.5% d. Thurbinar Ru = (7.75 + 7.875)/2 = 7.8125%; Harburtin Ru = 8.25%; Estimate = (8.25% + 7.8125%)/2 = 8.03%

Q5.

Q6. Your company operates a steel plant Q6. Your company operates a steel plant. On average, revenues from the plant are $30 million per year. All of the plants costs are variable costs and are consistently 80% of revenues, including energy costs associated with powering the plant, which represent one quarter of the plant’s costs, or an average of $6 million per year. Suppose the plant has an asset beta of 1.25, the risk-free rate is 4%, and the market risk premium is 5%. The tax rate is 40%, and there are no other costs. a. FCF = (30 – .8(30))(1-.40) = 3.6 million; Ru = 4% + 1.25  5% = 10.25%; V= 3.6/.1025 = 35.12 million b. FCF without energy = (30 – 18)(1 – .40) = 7.2; Cost of capital = 10.25%; Energy cost after tax = 3(1 – .40) = 1.8; Cost of capital = 4%; V = 7.2/.1025 – 1.8/.04 = 70.24 – 45 = 25.24 million c. FCF = 7.2 – 1.8 = 5.4; 5.4/25.24 = 21.4%; Risk is increased because now energy costs are fixed. Thus a higher cost of capital is appropriate.