2. CAPM, , AND FIRM’S RETURN Firm A is a levered with a leverage ratio B/S = 1/2
ID: 2667757 • Letter: 2
Question
2. CAPM, , AND FIRM’S RETURN
Firm A is a levered with a leverage ratio B/S = 1/2 where the overall annual borrowing rate of the outstanding debt is 5%. Firm A’s B is estimated to be 1.2 while the yearly stock market expected return is 10% in the future 5 years. The 1-year T-bill is expected to have a yield of 3% in the future 5 years. Also the tax rate to the ?rm is 35%.
(a) What’s the expected return on the stock (equity) using CAPM ?
(b) What’s the weighted average cost of capital of firms A ?
(c) Assume the firm has an investment opportunity with the total cash flows given below
{- 1000, 500, 600, 800, 700, 400}
What are the NPV and IRR of this project?
(d) Repeat the calculation in last two parts by assuming B/S = 2. Is the same project more profitable under this new leverage ratio?
Explanation / Answer
(a) Expected return on the stock by using CAPM is as follows. Expected return = Risk free rate +(Risk premium)*Beta of the stock = 3% + (10%-3%)*1.2 = 3% + 7%*1.2 = 3% + 8.4% = 11.4%. Therefore expected return on the stock is 11.4%. (b). WACC of firm A is calculated as follows. =(% of debt)*cost of debt*(1 - Tax bracket) + Cost of equity(% of Equity in capital structure). =50%*5%(1 - 35%) + 10%*50%. =0.5*5%*0.65 + 0.5%10% =1.625% + 5% =6.625%. WACC of firm A is 6.625%. (c) By using excel spread sheet we can calculate NPV. Inset NPV in formula bar and take the values as follows. Value1 = -1000 Value2 = 500 Value3 = 600 Value4 =800 Value5 =700 Value6 =400 Rate =10%. By enter we can get the answer as 2,227.94 - 1,000. NPV is $1,227.14. (d) Debt equiry ratio indicates leverage ratio. which is 2. Means for any firm optimal leverage ration is 2:1 is preferrable. No the new project is not profitable under this leverage ratio.Related Questions
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