8. Portfolio Risk and Return. According to the CAPM, would the expected rate of return on

a security with a beta less than zero be more or less than the risk-free interest rate? Why

would investors invest in such a security? (Hint: Look back to the auto and gold example in Chapter 11.) (LO12-1)

9. Risk and Return. Suppose that the risk premium on stocks and other securities did, in fact, rise with total risk (i.e., the variability of returns) rather than just market risk. Explain how investors could exploit the situation to create portfolios with high expected rates of return but low levels of risk. (LO12-2)

10.

CAPM and Valuation. You are considering acquiring a firm that you believe can generate expected cash flows of $10,000 a year forever. However, you recognize that those cash flows are uncertain. (LO12-2)a.

Suppose you believe that the beta of the firm is .4. How much is the firm worth if the risk-free rate is 4

% and the expected rate of return on the market portfolio is 11

%?b.

By how much will you overvalue the firm if its beta is actually .6?

1.

Changes in Capital Structure. Look at our calculation of Big Oil’s WACC in Section 13.5. (LO13-1)a.

Suppose Big Oil is excused from paying taxes. What would be its WACC?b.

Now suppose that, after the tax rate has fallen to zero, Big Oil makes a large stock issue and uses the proceeds to pay off all its debt. What would be the cost of equity after the issue?

3. WACC. Reactive Power Generation has the following capital structure. Its corporate tax rate is 21

%. What is its WACC? (LO13-1)

Security

Market Value

Required Rate of Return

Debt

$20 million

6

%

Preferred stock

10 million

8

Common stock

50 million

12

5. Calculating WACC. The total book value of WTC’s equity is $10 million, and book value per share is $20. The stock has a market-to-book ratio of 1.5, and the cost of equity is 15

%. The firm’s bonds have a face value of $5 million and sell at a price of 110

% of face value. The yield to maturity on the bonds is 9

%, and the firm’s tax rate is 21

%. Find the company’s WACC. (LO13-1)

18.

Cost of Debt. Olympic Sports has two issues of debt outstanding. One is a 9

% coupon bond with a face value of $20 million, a maturity of 10 years, and a yield to maturity of 10

%. The coupons are paid annually. The other bond issue has a maturity of 15 years, with coupons also paid annually, and a coupon rate of 10

%. The face value of the issue is $25 million, and the issue sells for 94

% of par value. The firm’s tax rate is 21

%. (LO13-4)

a.

What is the before-tax cost of debt for Olympic?

b.

What is Olympic’s after-tax cost of debt?

19.

Cost of Equity. Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 30

%, and the current dividend yield is 2

%. Its beta is 1.2, the market risk premium is 8

%, and the risk-free rate is 4

%. (LO13-4)

a.

Use the CAPM to estimate the firm’s cost of equity.

b.

Now use the constant growth model to estimate the cost of equity. c.

Which of the two estimates is more reasonable?