Question 4. Stern Alumni, a diversified conglomerate, is deciding whether to buy

Question

Question 4. Stern Alumni, a diversified conglomerate, is deciding whether to buy a copper mine. Stern Alumni already owns some gold mines and has recently invested in the biotech industry. Stern Alumni's cost of capital is currently 10%. The following is a list of other companies for which market data are available. As a simplifying assumption you can set all debt betas equal to zero. What opportunity cost of capital should Stern Alumni use for evaluating whether to buy the copper mine? Use a risk free rate of 7% and a market risk premium (rm-rf) of 8%.

Explanation / Answer

Calculation of Return on equity different firm wise.

For that we are using Formula: Re = Rf+Be{E(Rm)-Rf}

where, Re = Reuired return on equity, Rf = Risk Free rate, Be = Beta of the entity/company,(Rm-Rf) = Market Risk Premium

Now we are using Rational in that if firm's rate of return on its investement exceeds its cost of capital, equity shreholders benefit.

Rational for Cost of Capital = (Total return on the project - Interest on Debt) / Equity Funds

From above calculation Firm C meets its cost of capital will more benefited to its share holders.

So here Stren Alumni go for buy Firm C

Firm Retun on Equity A 7% + (1) (8%) = 15 % B 7%+(1.02) (8%) = 15.64 % C 7%+(0.8) (8%) = 13.4 % D 7%+(1.37)(8%) = 17.96 %

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