ISL333E
FINANCE
Problem Session 5
Q1
Stocks X and Y have the following probability distributions of
expected future returns:
Probability X Y
0.1 -10 -35
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
Q1
a) Calculate the expected rate of return ry, for Stock Y (rx = 12%).
b) Calculate the standard deviation of expected returns, σx, for Stock X (σy =
20.35%). Now calculate the coefficient of variation for Stock Y. Is it possible
that most investors will regard Stock Y as being less risky than Stock X?
Explain.
Q2
A stock has a required return of 11%, the risk-free rate is 7%, and the market
risk premium is 4%.
a. What is the stock’s beta?
b. If the market risk premium increased to 6%, what would happen to the
stock’s required rate of return? Assume that the risk-free rate and the beta
remain unchanged.
Q3
Dozier Corporation is a fast-growing supplier of office products. Analysts
project the following free cash flows (FCFs) during the next 3 years, after
which FCF is expected to grow at a constant 7% rate. Dozier’s WACC is 13%.
1. year -$20
2. year $30
3. year $40
a. What is Dozier’s horizon, or continuing, value? (Hint: Find the value of all
free cash flows beyond Year 3 discounted back to Year 3.)
b. What is the firm’s value today?
c. Suppose Dozier has $100 million of debt and 10 million shares of stock
outstanding. What is your estimate of current price per share?
Q4
Taussig Technologies Corporation (TTC) has been growing at a rate of 20%
per year in recent years. This same growth rate is expected to last for another
2 years, then decline to g= 6%.
If D0= $1.60 and rs= 10%, what is TTC’s stock worth today? What are its
expected dividend and capital gains yields at this time during Year 1?
Q5
Midwest Electric Company (MEC) uses only debt and common equity. It can
borrow unlimited amounts at an interest rate of rd= 10% as long as it finances
at its target capital structure, which calls for 45% debt and 55% common
equity. Its last dividend (D0) was $2, its expected constant growth rate is 4%,
and its common stock sells for $20. MEC’s tax rate is 40%.
Two projects are available: Project A has a rate of return of 13%, while Project
B’s return is 10%. These two projects are equally risky and about as risky as
the firm’s existing assets.
a. What is its cost of common equity?
b. What is the WACC?
c. Which projects should Midwest accept?
Q6
The Patrick Company’s year-end balance sheet is shown below. Its cost of
common equity is 16%, its before-tax cost of debt is 13%, and its marginal tax
rate is 40%. Assume that the firm’s long-term debt sells at par value. The firm
has 576 shares of common stock outstanding that sell for $4.00 per share.
Calculate Patrick’s WACC using market value weights.
Q6
Assets Liabilities and Equity
Cash $120
Accounts receivable 240
Inventories 360 Long-term debt $1152
Plant and equipment, net 2160 Common equity 1728
Total assets $2880 Total liabilities and equity $2880