BF3201 Corporate Finance and Strategy

Problem Set 2 Questions (Hurdle Rates)

In the problems below, use the following when none is specified
• 5.5% as your US market risk premium over Treasury bonds
• 8.76% as your US market risk premium over Treasury bills
• 40% as the tax rate

Q1. Risk and Return

You are in a world where there are only two assets, gold and stocks. You are interested in
investing your money in one, the other or both assets. Consequently, you collect the following
data on the returns on the two assets over the last six years.
Gold Stock Market
Average return 8% 20%
Standard deviation 25% 22%
Correlation -.4
a) If you were constrained to pick just one, which one would you choose?
b) A friend argues that this is wrong. He says that you are ignoring the big payoffs that you can
get on gold. How would you go about alleviating his concern?
c) How would a portfolio composed of equal proportions in gold and stocks do in terms of
mean and variance?
d) You now learn that GPEC (a cartel of gold-producing countries) is going to vary the amount
of gold it produces with stock prices in the US. (GPEC will produce less gold when stock
markets are up and more when it is down.) What effect will this have on your portfolios?
Explain.

Q2. Risk-free rates

The Mexican government has dollar denominated bonds yielding 8% and peso denominated
bonds yielding 12%. Both the dollar denominated bonds and peso denominated bonds are rated
BB by S&P. The treasury bond rate in the United States is 5%. What is the risk-free rate to use if
you were to calculate the cost of equity in dollars for a Mexican company? What if you are
calculating the cost of equity in peso instead?

Q3. Betas
Battle Mountain is a mining company that mines gold, silver, and copper in mines in South
America, Africa, and Australia. The beta for the stock is estimated to be 0.30. Given the
volatility in commodity prices, how would you explain the low beta?
Q4. Implied Market Risk Premium (Not covered in lecture)
You are trying to estimate the implied equity risk premium to use for an emerging market and
have been provided with the following information:

• The equity index for the market is currently trading at 10,500

• Based upon earnings in the just completed financial year, the market trades at a price
earnings ratio of 10.
• Earnings are expected to grow 5% a year in perpetuity and firms are expected to pay out
60% of their earnings as dividends in perpetuity.
• The risk-free rate for the market is 5.2%.

Estimate the implied equity risk premium for the emerging market, using the information
supplied in the problem.

Q5. Cost of Equity for Emerging Markets Company

You want to estimate the cost of equity for a company listed in Indonesia, and have been
supplied with the following information:

• Indonesia is rated BB by S&P, and the corporate bond spread over the US treasury bond rate
for BB rated bonds is 3.0%.
• The country market risk premium for Indonesian is 17.5%
• The firm has a beta of 0.75.
• It derives 80% of its revenues from US and only 20% of its revenues from Indonesia.

Estimate the cost of equity for this firm, if the Indonesian Rupiah riskfree rate is 15%, and the
risk premium for mature equity markets is 5.5%.

Q6. Bottoms-up Beta and Cost of Equity

You have been asked to estimate the beta for a large South Korean company, with large holdings
in steel and financial services. A regression of stock returns against the local market index yields
a beta of 1.10, but the firm is 15% of the index. You have collected the average betas for global
companies in each of the sectors, as well as the average debt equity ratios in each sector:

Sector Average Beta Average D/E ratio

Steel 1.18 30%
Financial Services 1.14 70%
(The marginal tax rate for these firms is 40%)
In the most recent period, the company you are analyzing earned 70% of its operating income
from steel and 30% from financial services. The firm also had a debt/equity ratio of 150%, and a
tax rate of 30%.
a) Estimate the beta for the company.
b) Would it be a good idea to use the historical beta?
c) If the Korean government bond rate in nominal Won is 12%, Korea’s rating is BBB (Country
bonds with this rating earn a spread of 2% over the U.S. long bond rate) and Korean market
risk premium is 9.5%, estimate the cost of equity for this company in Korean Won.

Q7. Financial Risk and Business Risk

Boise Cascade had debt outstanding of $1.7 billion and a market value of equity of $1.5 billion;
the corporate marginal tax rate was 36 percent. Assuming that the current beta of 0.95 for the
stock is a reasonable one, estimate the unlevered beta for the company.

Q8. Betas After Restructuring

Novell, which had a market value of equity of $2 billion and a beta of 1.50, announced that it
was acquiring WordPerfect, which had a market value of equity of $1 billion and a beta of 1.30.
Neither firm had any debt in its financial structure at the time of the acquisition, and the
corporate tax rate was 40 percent.
a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was
financed with equity.
b. Assume that Novell had to borrow the $1 billion to acquire WordPerfect. Estimate the beta
after the acquisition.

Q9. Divisional and Corporate Betas

You are analyzing the beta for Hewlett Packard and have broken down the company into four
broad business groups, with enterprise values and betas for each group. HP had $1 billion in debt
outstanding. Assume tax rate of 36%.

Business Group Enterprise Value Unlevered Beta

Mainframes $2.25 billion 1.10
Personal computers 2.25 billion 1.50
Software 1.25 billion 2.00
Printers 3.25 billion 1.00

a) Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the beta
estimated by regressing past returns on their stock against a market index. Why or why not?
 Assume ERP is 5.5%
b) If the Treasury bond rate is 7.5 percent, estimate the cost of equity for Hewlett Packard.
Estimate the cost of equity for each division, assuming that HP’s overall debt-equity ratio
applies for each division. Which cost of equity would you use to value the printer division?
c) Assume that HP divests itself of the mainframe business for $2.25billion and use all the
proceeds to buy back stock. Estimate the beta for HP after the divestiture.

Q10. Betas after Restructuring

You have just run a regression of monthly returns on MAD, a newspaper and magazine
publisher, against returns on the S&P 500, and arrived at the following result:

RMAD = – 0.05% + 1.20 RS&P

The regression has an R2 of 22 percent. The current Treasure bill rate is 5.5 percent and the
current Treasury bond rate is 6.5 percent. The risk-free rate during the period of the regression
was 6 percent.

You now realize that MAD went through a major restructuring at the end of last month (which
was the last month of your regression), and made the following changes:
• The firm sold off its magazine division, which had an unlevered beta of 0.6, for $20 million.
• It borrowed an additional $20 million, and bought back stock worth $40 million.
• After the sale of the division and the share repurchase, MAD had $40 million in debt and
$120 million in equity outstanding. If the firm’s tax rate is 40 percent, reestimate the beta
after these changes.

Q11. Cash and Betas

Chrysler, the automotive manufacturer, had a beta of 1.05 in 1995. It had $13 billion in debt
outstanding in that year and 355 million shares trading at $50 per share. The firm had a cash
balance of $8 billion at the end of 1995. The marginal tax rate was 36 percent.

a) Estimate the unlevered beta of the firm including and excluding cash.
b) Estimate the effect of paying out a special cash dividend of $5 billion on the unlevered beta
of the whole firm.
c) Estimate the levered beta for Chrysler after the special dividend.

Q12. Implied Equity Risk Premium, Cost of Equity and Cost of Capital
You have been asked to estimate the cost of capital for Baklak Stores, a specialty retail firm that
generates all of its revenues in Thailand. You are supplied with the following additional
information:
• The average beta for specialty retailers in South East Asia is 1.20, and the average debt to
equity ratio for these firms is 45%.
• Baklak Stores has 100 million shares trading at 24 Malaysian Ringgit per share and debt
of 600 million Ringgit.
• The riskfree rate in Thai Baht is 9% and that tax rate for all firms is 40%.
• Baklak is not rated, but it does have recent borrowing in its books and the interest rate on
the debt is 11%.

a) The Thai stock index is trading at 800, the dividend yield on the index is 5% and the
expected growth rate in perpetuity in dividends is 10%. Estimate the implied equity risk
premium on the Thai index. (This question is not covered, but it is just for your reference if
you want to know more about how to use implied equity risk premium)
b) Estimate the cost of equity for Baklak Stores.
c) Estimate the cost of capital for Baklak Stores in Thai Baht.

Q13. Bottom-up Beta, Market Value of Debt, and Cost of Equity

You have been asked to estimate the cost of equity for Holton Holdings, a firm with operations
in three different businesses – retailing, hotels and travel. You have collected information on the
firm’s operations and of comparable firms in each of the businesses.

Comparable firms
Revenues Unlevered beta Firm Value/
Sales
Retailing $ 400 million 0.85 2.0
Software $ 400 million 1.15 3.0
Travel $ 800 million 1.35 1.25

a) Estimate the bottom-up unlevered beta for Holton Holdings.

b) Holton Holdings has no market-traded debt. The firm does, however, have $ 1.2 billion in
book debt and an interest expense of $ 60 million annually. If the debt has an average
maturity of 5 years, and the fair market rate for debt for the firm is 7%, estimate the market
value of the debt.
c) Holton Holdings has 100 million shares outstanding trading at $ 10 a share. In conjunction
with the estimated market value of debt in (b), estimate the bottom-up levered beta for the
firm. (You can assume a marginal tax rate of 40%.)
Q14. Cost of Capital and Operating Leases
You are trying to compute the cost of capital for a retail firm with significant operating lease
commitments and some conventional debt and have collected the following information:

• There are two classes of shares outstanding in the firm: 12 million of non-voting shares
that trade at $ 10 a share and 2.5 million voting shares that do not trade but have an
estimated value of $ 12 a share.
• The firm has a bank loan on its books with a face value of $ 50 million, with 5 years left
to maturity. The stated interest rate on the loan is 5%, but the company currently is rated
BBB and the market interest rate on BBB rated bonds is 6%.
• The firm has expected lease commitments of $15 million each year for the next 8 years.
• The cost of equity for the firm is 10%. The effective tax rate is 30% and the marginal tax
rate is 40%

Estimate the cost of capital for the firm.

Q15. Convertible Debt and Cost of Capital

B&N is a book retailer, which earned $ 1 billion before interest and taxes, but after $300million
in operating lease expenses last year; the firm has commitments to make $300million in lease
payments for the next 6 years. The firm had interest expenses of $100million per year on a 5-
year convertible debt with a face value (book value) of $2 billion; the bonds trade at a market
value of $ 2.5billion. Assume that B&N is rated BBB, and that the default spread on BBB rated
bonds is 2% over the treasury bond rate. Finally, the firm also had 300 million shares
outstanding, trading at $10 per share. The stock has a beta of 1.25, the tax rate is 40% and the
treasury bond rate is 5.5% (Market risk premium = 6.3%).

a) Estimate the market value of the debt in this firm.

b) Estimate the cost of capital for this firm.

Q16. Cost of Equity for Foreign Stocks

You are analyzing Siderar, an Argentine steel company, with ADRs listed on the New York Stock
Exchange and have uncovered four regressions for the stock:
ReturnSiderar = 0.05% + 1.30 Merval R-sq= 65%
ReturnSiderar = -0,03% + 0.70 S&P 500 R-sq = 23%
ReturnSiderar = -0,08% + 0.90 MSCI R-Sq = 20%
ReturnSiderar = 0.15% + 1.20 GlSTL R-Sq = 70%
(Merval: Argentine equity index; MSCI: Global Equity Index; GISTL: Index of steel companies
globally)
The Argentine government has ten-year peso denominated bonds trading at 11%, the bonds are
rated BB+ by S&P with a default spread of 2.5%. The ten-year U.S. treasury bond rate is 4%. An
analysis of the top investors in Siderar indicates that 12 of the top 17 investors are global mutual
funds. The country market risk premium for Argentinian stock market is 8.54%. Estimate a
nominal peso cost of equity for Siderar. The equity risk premium for US is 4.79%.