Chapter 09 - Risk and the Cost of Capital

CHAPTER 9
Risk and the Cost of Capital

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. the expected return on debt; If the debt has very low default risk, this is
close to its yield to maturity.

b. the expected return on equity

c. a weighted average of the cost of equity and the after-tax cost of debt,
where the weights are the relative market values of the firm’s debt and
equity

d. the change in the return of the stock for each additional one percent
change in the market return

e. the change in the return on a portfolio of all the firm’s securities (debt and
equity) for each additional one percent change in the market return

f. a company specializing in one activity that is similar to that of a division of

a more diversified company

g. a certain cash flow occurring at Time t with the same present value as an
uncertain cash flow at Time t

Est. Time: 06 -10

2. a. False; The company cost of capital is the correct discount rate for new
projects only if the new projects have the same risk level as the existing
business. If a new project is riskier, a higher cost of capital should be
used. If the new project is less risky, a lower cost of capital should be
used.

b. False; In order to account for the riskiness inherent in distant cash flows, it
is necessary to account for several possible outcomes in cash flows and
calculate the probability-weighted cash flow for each scenario. The
discount rates should not be adjusted based on uncertainty in cash flows.

c. True; A fudge factor applied to a discount rate would compound over time
thereby undervaluing a project.

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Chapter 09 - Risk and the Cost of Capital

Est. Time: 01 - 05

3. Quark will over-estimate the value of high-risk projects (i.e. future cashflows will
be discounted at a rate less than what is necessary).

Est. Time: 01 - 05

4. a. requity = rf + (rm – rf)

requity = .04 + 1.5  .06
requity = .13, or 13%

b. rassets = (D / V)rdebt + (E / V)requity

rassets = $4m / ($4m + 6m) × .04 + $6m / ($4m + 6m) × [.04 + 1.5(.06)]
rassets = .094, or 9.40%

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 percent.

d. rassets = (D / V)rdebt + (E / V)requity

rassets = $4m / ($4m + 6m) × .04 + $6m / ($4m + 6m) × [.04 + 1.2(.06)]
rassets = .0832, or 8.32%

Est. Time: 06 -10

5. Market values:

Debt = $300,000
Equity = 10,000 × $50 = $500,000
Total = $300,000 + 500,000 = $800,000

rassets = $300,000 / $800,000 × .08 + $500,000 / $800,000 × .15

rassets = .1238, or 12.38%

Est. Time: 06 -10

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Chapter 09 - Risk and the Cost of Capital

6. a. Total market value = $100m + 40m + 299m

Total market value = $439m

Asset = $100m / $439m × 0 + $40m / $439m × .20 + $299m / $439m ×

1.20
Asset = .836

b. r = rf + (rm – rf)
r = .05 + .836(.06)
r = .1001, or 10.01%

Est. Time: 01 - 05

7. Company cost of capital = .4(.10) + .6(.10 + .5 × .08)

Company cost of capital = .124, or 12.4%

After-tax WACC = .4[.10 × (1 – .2)] + .6(.10 + .5 × .08)

After-tax WACC = .116, or 11.6%.

Est. Time: 01 - 05

8. Debt ratio = Market value of debt / Total market value of debt and equity
Debt ratio = $5 million / [$5 million + (500,000 × $18)]
Debt ratio = .3571, or 35.71%

Est. Time: 06 -10

9. R-squared measures the proportion of the total variance in the stock’s returns
that can be explained by market movements. U.S. Steel’s R 2 shows that .15, or
15 percent of variation was due to market movements; the remainder, (1 –.15)
= .85, or 85 percent, of the variation was diversifiable. Diversifiable risk shows up
in the scatter about the fitted line. The standard error of the estimated beta
was .93. If you said that the true beta was 2 × .93 = 1.86 for either side of your
estimate, you would have a 95 percent chance of being right. The beta shown in
the graph is 3.01.

Est. Time: 01 - 05

10. a. According the analysis of the three securities, a diversified investor would
be safest to invest in the lowest market risk stock of Newmont, with
β=0.10.

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Chapter 09 - Risk and the Cost of Capital

b. For the undiversified investor, the least risky option is IBM with a standard
deviation of returns of 17.5%.

c. With equal weightings of each stock, the portfolio would contain the
average beta:

Portfolio beta = (1/3) x 0.94 + (1/3) x 0.10 + (1/3) x 1.26 = 0.77

d. Since all the stocks have equivalent market risk to Ford, the portfolio
would also have a beta of 1.26. However, since the idiosyncratic risk in
the portfolio will be eliminated through diversification (assuming here low
correlations given that the portfolio is “well” diversified) the portfolio would
have a standard deviation of 25.20% or 1.26 times the market of standard
deviation of 20%.

e. IBM = 4% + 0.94 x (8%) = 11.52%

Newmont = 4% + 0.10 x (8%) = 4.80%
Ford = 4% + 1.26 x (8%) = 14.08%

Est. Time: 06 -10

11. a. The R2 value for Sun Life Financial was .12, which means that 12
percent of total risk comes from movements in the market, i.e., market
risk. Therefore, (1 – .12) = .88, or 88 percent of total risk is unique risk.

The R2 value for Loblaw’s was .06, which means that 6 percent of total
risk comes from movements in the market and 94 percent is unique
risk.

b. The variance of Sun Life Financial is: (18.7) 2 = 349.7

Variance due to the market = ..12 × 349.7 = 42
Variance of diversifiable returns = (1 – .12) × 349.7 = 307.7

c. 95% confidence intervalLoblaw’s = β ± 2(Std error of β)

95% confidence intervalLoblaw’s = .63 ± 2(.33)
95% confidence intervalLoblaw’s = –.03 to 1.29

d. rSLF = rf + SLF  (rm – rf)

rSLF = .05 + .86(.12 – .05)]
rSLF = .1102, or 11.02%

e. rSLF = rf + SLF  (rm – rf)

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Chapter 09 - Risk and the Cost of Capital

rSLF = .05 + .86(20 – .05)]

rSLF = .1790, or 17.9%

Est. Time: 06 -10

12. a. rUP = rf + UP  (rm – rf) =

rUP = .02 + 0.90  (.07)
rUP = .083, or 8.3%

rIND = rf + IND  (rm – rf)

rIND = .02 + 1.25  (.07)
rIND = .1075, or 10.75%

Difference = 8.3% – 10.75% = –2.45%

Union Pacific’s cost of equity is 22.8 percent lower when based on the
firm’s beta rather than the industry beta.

b. No, we cannot be confident that Union Pacific’s true beta is not the
industry average. The difference between IND and UP (.35 = 1.25 – 0.90)
is less than the 95% confidence interval represented by two standard
errors (.44), so we cannot reject the hypothesis that IND = UP with 95%
confidence.

c. Union Pacific’s beta might be different from the industry beta for a variety
of reasons. For example, Union Pacific’s business might be less cyclical
than is the case for the typical firm in the industry. Or Union Pacific might
have lower fixed operating costs so that its operating leverage is lower.
Another possibility is that Union Pacific might have less debt than is typical
for the industry so that it has less financial leverage.

d. The large fluctuation in estimated beta lowers the confidence in the firm
specific estimate for Union Specific. Therefore, the cost might better be
estimated using an industry beta measure.

Est. Time: 06 -10

13. a. Project A; a project with higher fixed costs generally has higher operating
leverage, which leads to a higher beta

b. Project C; airline revenue is more cyclical than cereal revenue

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Chapter 09 - Risk and the Cost of Capital

Est. Time: 01 - 05

14. Asset β = .5 × .15 + .5 × 1.25

Asset β = .7

Est. Time: 01 - 05

15. Financial analysts or investors working with portfolios of firms may use industry
betas. To calculate an industry beta we would construct a series of industry
portfolio investments and evaluate how the returns generated by this portfolio
relate to historical market movements.

Est. Time: 01 - 05

16. a. If you agree to the fixed price contract, operating leverage will increase.
Changes in revenue will result in greater than proportionate changes in
profit. Business risk as measured by assets will also increase.

b. With the fixed price contract:

PV(assets) = PV(revenue) – PV(fixed cost) – PV(variable cost)

PV(assets) = $20 million / .09 – $10 million × ((1 / .06) – {1 / [.06(1 +
.06)10]}) – [(.50 × $20 million) / .09] / (1 + .09)10
PV(assets) = $101,686,818

Without the fixed price contract:

PV(assets) = PV(revenue) – PV(variable cost)

PV(assets) = $20 million / .09 – (.50 × $20,000,000) / .09
PV(assets) = $111,111,111

Est. Time: 06 -10

17. A diversifiable risk is unique to the project but has no effect on the risk of a well-
diversified portfolio. If a risk is diversifiable it does not affect the cost of capital for
the project. However, any possibility of bad outcomes should be reflected in the
project cash flows.

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Chapter 09 - Risk and the Cost of Capital

18. Suppose the expected cash flow in Year 1 is $100, but the project proposer
provides an estimate of $100 × 115/108 = $106.50. Discounting this figure at 15
percent gives the same result as discounting the true expected cash flow at 8
percent. Adjusting the discount rate, therefore, works for the first cash flow but it
does not do so for later cash flows, e.g., discounting a 2-year cash flow of
$106.50 by 15 percent is not equivalent to discounting a 2-year flow of $100 by 8
percent. By adjusting the discount rate, the project’s NPV will be less than it
should be.

Est. Time: 01 - 05

19. a. The threat of a coup d’état means that the expected cash flow is less
than $250,000. The threat could also increase the discount rate, but
only if it increases market risk.

b. The unbiased forecast is:

Expected cash flow = (.25  $0) + (.75  $250,000)

Expected cash flow = $187,500

Assuming the cash flow is about as risky as the rest of the company’s
business:

PV = $187,500 / (1 + .12)
PV = $167,410.71

Est. Time: 01 - 05

20. a. Daily production = (.2  0) + .8  [(.4 × 1,000) + (.6 × 5,000)]

Daily production = 2,720 barrels

Annual cash revenues = 2,720 × 365 × $100

Annual cash revenues = $99,280,000

b. The possibility of a dry hole is a diversifiable risk and should not affect
the discount rate. This possibility affects forecasted cash flows, as seen
in part a. The appropriate discount rate for the project is the oil
company’s normal cost of capital.

Est. Time: 06 -10

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Chapter 09 - Risk and the Cost of Capital

21. a. requity = rf +   (rm – rf)

requity = .05 + .5 × .10
requity = .10

PV = $110 / (1 + .10) + $121 / (1 + .10)2

PV = $200.00

b. To solve for the certainty equivalent for the first year:

CEQ1 / (1 + .05) = $110 / (1 + .10)

CEQ1 = $105.00

For Year 2:

CEQ2 / (1 + .05)2 = $121 / (1 + .10)2

CEQ2 = $110.25

c. Ratio1 = $105 / $110

Ratio1 = .95

Ratio2 = $110.25 / $121

Ratio2 = .91

Est. Time: 06 -10

22. a. Using the Security Market Line:

r = .07 + 1.5(.16 – .07)]

r = .2050, or 20.50%

PV = –$100 + $40 / (1 + .205) + $60 / (1 + .205)2 + $50 / (1 + .205)3

PV = $3.09

b. CEQ1 = $40 × [(1 + .07) / (1 + .205)]1 = $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 = .8880

a2 = $47.31 / $60 = .7885
a3 = $35.01 / $50 = .7001
d. Using a constant risk-adjusted discount rate is equivalent to assuming
that at decreases at a constant compounded rate.
Est. Time: 11 -15

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Chapter 09 - Risk and the Cost of Capital

23. At t = 2, there are two possible values for the project’s NPV:

NPV 2 launch = –$5,000,000 + $700,000 / .12 = $833,333

NPV2 withdraw = $0

Therefore, at t = 0:

NPV0 = –$500,000 + {(.60 × $833,333) + [(1 – .60) × $0]} / (1 + .20)2

NPV0 = –$152,778

Est. Time: 06 -10

24. It is correct that, for a high beta project, you should discount all cash flows at a
high rate. Thus, the higher the risk of the cash outflows, the less you should
worry about them because the higher the discount rate, the closer the present
value of these cash flows is to zero. This result does make sense. It is better to
have a series of payments that are high when the market is booming and low
when it is slumping (i.e., a high beta) than the reverse.
The beta of an investment is independent of the sign of the cash flows. If an
investment has a high beta for anyone paying out the cash flows, it must have a
high beta for anyone receiving them. If the sign of the cash flows affected the
discount rate, each asset would have one value for the buyer and one for the
seller, which is clearly an impossible situation.

Est. Time: 06 -10

25. a. Since the risk of a dry hole is unlikely to be market related, we can use
the same discount rate as for producing wells.

rnominal = .06 + .9(.08)

rnominal = .1320, or 13.20%

rreal = (1 + .1320) / (1 + .04) – 1

rreal = .0885, or 8.85%

b. Based on the executive’s proposal:

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Chapter 09 - Risk and the Cost of Capital

Discount rate = .0885 + .20 = .2885

NPV1 = –$10 million + $3 million × ((1 / .2885) – {1 / [.2885(1 + .2885)10]})

NPV1 = –$424,743

NPV2 = –$10 million + $2 million × ((1 / .2885) – {1 / [.2885(1 + .2885)15]})

NPV2 = –$3,221,502

c. Expected income from Well 1: [(0.2  0) + (0.8  3 million)] = $2.4 million

Expected income from Well 2: [(0.2  0) + (0.8  2 million)] = $1.6 million

Discounting at 8.85%:

NPV1 = –$10 million + $2.4 million × ((1 / .0885) – {1 / [.0885(1

+ .0885)10]})
NPV1 = $5,507.230

NPV2 = –$10 million + $1.6 million × ((1 / .0885) – {1 / [.0885(1

+ .0885)15]})
NPV2 = $3,015,074

d. For Well 1, one can certainly find a discount rate (and hence a “fudge
factor”) that, when applied to cash flows of $3 million per year for 10
years, will yield the correct NPV of $5,504,600. Similarly, for Well 2, one
can find the appropriate discount rate. However, these two “fudge factors”
will be different. Specifically, Well 2 will have a smaller “fudge factor”
because its cash flows are more distant. With more distant cash flows, a
smaller addition to the discount rate has a larger impact on present value.

Est. Time: 16 -20

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