Advanced Corporate Finance Leonidas Rompolis

EXERCISES -3 (SOLUTIONS)

Chapter 9, Practice Questions

1. a. requity = rf + β × (rm – rf) = 0.04 + (1.5 × 0.06) = 0.13 = 13%

D E ⎛ $4million ⎞ ⎛ $6million ⎞
b. rassets = rdebt + requity = ⎜ ×0.04 ⎟ + ⎜ ×0.13 ⎟
V V ⎝ $10million ⎠ ⎝ $10million ⎠
rassets = 0.094 = 9.4%

c. The cost of capital depends on the risk of the project being evaluated. If the
risk of the project is similar to the risk of the other assets of the company, then
the appropriate rate of return is the company cost of capital. Here, the
appropriate discount rate is 9.4%.

d. requity = rf + β × (rm – rf) = 0.04 + (1.2 × 0.06) = 0.112 = 11.2%

D E ⎛ $4million ⎞ ⎛ $6million ⎞
rassets = rdebt + requity = ⎜ ×0.04 ⎟ + ⎜ ×0.112 ⎟
V V ⎝ $10million ⎠ ⎝ $10million ⎠
rassets = 0.0832 = 8.32%

5. a. The R2 value for BP was 0.27, which means that 27% of total risk comes from
movements in the market (i.e., market risk). Therefore, 73% of total risk is
unique risk.
The R2 value for BA was 0.37, which means that 37% of total risk comes from
movements in the market (i.e., market risk). Therefore, 63% of total risk is
unique risk.
b. The variance of BP is: (0.25)2 = 0.0625
Market risk for BP: 0.27 × 0.0625 = 0.0168
Unique risk for BP: 0.73 × 0.0625 = 0.456
d. rBA = rf + βBA × (rm – rf) = 0.05 + 2.12 × (0.12 – 0.05) = 0.01984 = 1.98%

e. rBA = rf + βBA × (rm – rf) = 0.05 + 2.12 × (0 – 0.05) = -0.056 = -5.6%

9. a. The threat of a coup d’état means that the expected cash flow is less than
$NZ 900 million. The threat could also increase the discount rate, but only if it
increases market risk.
b. The expected cash flow is: (0.2 × 0) + (0.8 × 900) = $NZ 720 million.
Assuming that the cash flow is about as risky as the rest of the company’s
business:

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 Advanced Corporate Finance Leonidas Rompolis

720
NPV = −1, 200 + 500 + = −105
1.12

10. a. If you agree to the fixed price contract, operating leverage increases. Changes
in revenue result in greater than proportionate changes in profit. If all costs
are variable, then changes in revenue result in proportionate changes in profit.
Business risk, measured by βassets, also increases as a result of the fixed price
contract. If fixed costs equal zero, then:
βassets = βrevenue. However, as PV(fixed cost) increases, βassets increases.

b. With the fixed price contract:

PV(assets) = PV(revenue) – PV(fixed cost) – PV(variable cost)
$20million $10million
PV(assets)= -($10million)×(annuity factor 6%,10years)-
0.09 (0.09)×(1.09)10
PV(assets) = $101,687,000
Without the fixed price contract:
PV(assets) = PV(revenue) – PV(variable cost)
$20million $10million
PV(assets)= -
0.09 0.09
PV(assets) = $111,111,111

15. a. Using the Security Market Line, we find the cost of capital:
r = 0.07 + 1.5 × (0.16 – 0.07) = 0.205 = 20.5%
Therefore:
40 60 50
PV = + 2
+ = 103.09
1.205 1.205 1.2053
b.
CEQ1 = 40×(1.07/1.205) = 35.52
CEQ2 = 60×(1.07/1.205)2 = 47.31
CEQ3 = 50×(1.07/1.205)3 = 35.01
c.
a1 = 35.52/40 = 0.8880
a2 = 47.31/60 = 0.7885
a3 = 35.01/50 = 0.7002

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Advanced Corporate Finance Leonidas Rompolis

d. Using a constant risk-adjusted discount rate is equivalent to assuming that at

decreases at a constant compounded rate.