Exercise 3 (2 points)
You are given the following information about possible investments:
Asset
|
Expected Return
|
Std. Deviation
|
Correlation with the Mkt
|
Beta
|
Value Stock
|
18%
|
30%
|
1
|
|
Growth Stock
|
|
20%
|
0.5
|
|
Gold
|
|
20%
|
-0.5
|
|
T-bill
|
6%
|
0%
|
0
|
0
|
Can you fill in the blanks?
Exercise 4 (5 points)
The Sunshine company is considering two projects, project A and project B. Project A requires the purchase of an equipment but no working capital investment whereas project B requires a working capital investment but no equipment. The relevant information for net present value analysis is given below:
Project A Project B
Cost of equipment $600,000
Working capital needed $600,000
Annual cash inflows $160,000 $120,000
Salvage value (scrap value) of equipment $ 40,000
Project life 8 years 8 years
The working capital required for project B will be released at the end of project life.
Suppose the project has a beta of 0.75. The market risk premium is 20%. The risk-free rate is 3%.
What is Sunshine’s WACC?
What is the best investment project? Use the net present value (NPV) method and explain your answer.
=> Project A is better.
Without redoing the calculations can you say if the NPV of project A would increase or decrease if the beta of the project were 1? Explain you answer.
If the beta of the project is 1 (the beta increases), WACC increases => discount factor decreases => the NPV of project A will decrease.
Exercise 5 (5 points)
Indicate which of the following statements is true or false. Provide a two-sentence justification for each answer.
Consider two financial assets, A and B. Asset A is has volatility of 20%; Asset B has a volatility of 30%. Asset A will have for sure lower expected returns.
FALSE
Though asset A is less riskier than asset B, it does not mean asset A has lower expected return. “High risk, high return” is only common sense, which is not true in every case.
Other things being equal, the value of a coupon bond will increase when its yield-to-maturity increases.
FALSE
Based on formula above, the yield-to-maturity increases => N increases => (1+y)^N increases
=> the value of that coupon bond will decrease.
Diversification will not reduce the total risk of a portfolio if all constituent stocks are very volatile.
FALSE
“Very volatile” here is not clear enough. We cannot take any advantage of diversification only when correlations between constituent stocks are 1 (they are perfectly positively correlated). In this case we cannot build an efficient portfolio.
When leverage increases, the risk of equity return increases, and so does the WACC.
FALSE
The expected return of equity will increase.
When there is no tax: the WACC will be constant no matter what happens with capital structure.
When the firm has to pay taxes: the WACC will decrease when leverage increases.
The fact that dividend-paying firms have a lower value than share-repurchasing firms indicates that shareholders prefer share repurchases.
TRUE
Thanks to leverage, share-repurchasing firms can increase the equity cost of capital. It means these firms have a higher value than dividend-paying ones. In this case, Earnings per share (EPS) increases (since outstanding shares decreases). Therefore, shareholders prefer share repurchases because they can gain more money.
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