The risk-free rate of interest is 3% and the market risk premium is 5%. Alpha Co
ID: 2718824 • Letter: T
Question
The risk-free rate of interest is 3% and the market risk premium is 5%. Alpha Company’s hardware division has an asset beta of 1.4, a free cash flow of $450 million, and an expected growth rate of 4.0%. The value of the hardware division (in $millions) is closest to __________.
$4,500
$7,500
$8,750
$10,000
The risk-free rate of interest is 3% and the market risk premium is 5%. Alpha Company’s hardware division has an asset beta of 1.4, a free cash flow of $450 million, and an expected growth rate of 4.0%. The value of the hardware division (in $millions) is closest to __________.
$4,500
$7,500
$8,750
$10,000
Explanation / Answer
Answer:
The expected rate return = Risk free rate + Beta * Market risk premium
= 3% + 1.4 * 5% = 10%
The value of hardware division = free cash flow/ (Expected rate of return - Growth rate)
= {$450 million} /(10% - 4%) = $7,500 million (ans)
(assumed that asset beta = overall beta in the absence of debt and equity ratio)
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