3. Hot Pockets Corporation is considering going public. Managers want to estimat

Question

3. Hot Pockets Corporation is considering going public. Managers want to estimate common stock value. The standard deviation of returns for this firm is 20%. The firm's beta is 0.8. 3-month T-Bills currently trade at a discount to par of 1% on an annualized basis. The expected return on the stock market is 10%. There are 10,000 shares of common stock outstanding. Assume the firm's capital structure is 50% debt, 50% common equity, the cost of debt is 6%, and the marginal tax rate for the firm is 21% a) What is the total risk of this firm, and what is its systematic risk? b) What is the expected return of this stock? What is the name of the model you use to estimate it? c) What is the Weighted Average Cost of Capital for the firm? d) If the firm's estimated free cash flows over the next 3 years are: Year 2018 2019 2020 Estimated Free Cash Flow S100,000 S200,000 S300,000 and after 2020 to infinity, expected free cash flows will grow at a rate of 4% per year: (i) what is the value of its equity outstanding; and (ii) what would be the price per share? e) (i) If an investor in Hot Pockets owns equal amounts of Hot Pockets, Nextera Energy, Southwest Airlines, and Caterpillar common stock, what will the market risk of his/her portfolio be? (Assume standard deviation of 10%. 30%, and 25%, and beta of .5, 1.5, and 1 for each of Nextera Energy, Southwest Airlines, and Caterpillar common stock.) (ii) Given the above information, what will be the percentage return on this investor's portfolio if the market goes up 10%?

Explanation / Answer

Total Risk of the firm = Standard Deviation = 20%

Risk free rate Rf = 1% ( discount to par on an annualized basis for 3-month t-bill)

Rm = Expected Return on the Stock Market

Systematic Risk is represented by Beta * (Rm - Rf) = 0.8 * (10% - 1%) = 0.8 * 9% = 7.2%

Expected Return on the Stock = Rf + Beta * (Rm - Rf) = 1% + 0.8 * (10% - 1%) = 8.2%

Thus, cost of Equity = 8.2%

The name of the model is the Capital Asset Pricing Model

WACC = proportion of debt * after tax cost of debt + proportion of equity * cost of Equity

= 0.5 * 6% * (1-0.21) + 0.5 * 8.2%

= 6.47%

Related Questions

Navigate

• Browse (All)
• Browse 3
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.