You have been hired to estimate the beta for HP and have broken the company down
ID: 2806806 • Letter: Y
Question
You have been hired to estimate the beta for HP and have broken the company down into 4 broad business groups. The market values and equity betas for each group are shown on the table below:
Division ‘s equity Market Value
Business Group Market Value Asset Beta Division Debt
(in $billions) (in $billions)
Mainframes $2.0 1.10 $0.75
Personal Computers $2.0 1.50 $0.50
Software $1.0 2.00 $1.00
Printers $3.0 1.00 $1.25
________________________________________________________________
Estimate the equity beta for HP as a company.
If the market risk premium is 5% and the T-Bond rate is 2%, determine how much of the return HP’s shareholders’ earn is due to business (asset) risk, and how much is due to financial risk.
Assume you are HP’s CEO. Outside investors would like to know what WACC (s) you use to evaluate each division’s projects. Would you use one for each division, or one for the entire firm. Why? Please explain.
Explanation / Answer
3)I used CAPM model to evaluate each division’s projects where the inesvtor can analyse the minimun expected rate of return to buy the stock of each division. However WACC's of each division is derived diffrerent rate of returns and entire company WACC is 0.8% and software division's return rate (0.12) which shows the higher WACC than other division's hence I would like to suggest investor to go with the entire firm WACC so that one can easily estimates financial position of the entire firm to purchase the stock as a whole. The risk and the cost of capital (WACC) of the the each project calculates the different values of risks as we collected the diffrent unlevered beta of each divisions. Since the overall project WACC indicates the perfect required rate of the return. Based on which company owners can weighted the capital proportionately and outside investors can access the future growth of opportunities to meet the expected rate of returns.
Business Group Division ‘s equity (in $billions) Division Debt (in $billions) Market Value Asset Beta Market Value Mainframes $2.00 $1.10 $0.75 Personal Computers $2.00 $1.50 $0.50 Software $1.00 $2.00 $1.00 Printers $3.00 $1.00 $1.25 $8.00 $5.60 $3.50 1) Estimate the equity beta for HP as a company. We need to calculate the the weighted average of betas as per the given market Value of equity of each division. Unlevered Beta =( 2.0/8.0) x 1.1 + (2.0/8.0) x 1.5 + (1.0/8.0) x 2.00 + 3.0/8.0 x 1.00 = (2/8)*1.1+(2/8)*1.5+(1/8)*2+(3/8)*1 Betas determine cost of capital:= 1.275 2)If the market risk premium is 5% and the T-Bond rate is 2%, determine how much of the return HP’s shareholders’ earn is due to business (asset) risk, and how much is due to financial risk. market risk premium is 5% and the T-Bond rate is 2%, The required rate of return earned by the HP's sharehaolder earn is due the business (asset) risk Hence The total value of the firm = Market Value of Equity+ Market Value of debt $8+$3.50 11.5 CAPM model Cost of Equity (rate of return of the firm) in terms of asset risk (expected return)= Risk-Free Rate + (Beta * Market Risk Premium) which require market rate of return and beta of the stock and risk free rate. Cost of Equity = Risk-Free Rate + Beta * (Market risk premium)= 2.00% + 1.275 (5.00%) 0.08 Unlevered beta means Asset beta which is not dependent on debt amount hence equity beta = asset beta when D/E=0 We need to calculate the value of Unlevered beta of each division with formula as = Beta (asset) = Mainframes Cost of Equity = 2% + 1.10 (5.00%) 0.075 Personal Computers Cost of Equity = 2% + 1.50 (5.00%) 0.095 Software Cost of Equity = 2% + 2.00 (5.00%) 0.12 Printer's Cost of Equity 2% + 1.00 (5.00%) 0.07 Financial Leverage ratio of firm indicates the financial risk of the company which is combination of debt and equity of the firm (debt to equity ratio and debt to capital ratio)= 1)Debt/equity 2)Debt/ capital = 1) $3.5/$8 2)$3.5/$11.5 =0.44 = 0.30 Conclusion: Both the ratio's indicates the lower figures as 0.43 and .30 means which is lower than ideal ratio 1 which has less debt comparatively in the form of capitalRelated Questions
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