CAPM Finance Assingment Help With Solution

1. Answer the following questions pertaining to cost of capital and capital budgeting.

(a) Consider a firm whose common stock has a CAPM beta of 1.2. The risk-free rate is 4.5 percent
and the expected return on the market portfolio is 13 percent.

(i) What is the firm’s equity capital?

(ii) Suppose that the firm has an outstanding debt issue with 12 years to maturity and is priced at
105 percent of face value. The bond issue makes payments semiannually and pays an annual
coupon rate of 8 percent. What is the firm’s pretax cost of debt? (Hint: What is the discount
rate that correctly prices the firm’s debt?)

(iii) If the firm is in the 35 percent corporate tax bracket, what is its aftertax cost of debt?

(iv) The firm’s debt-equity ratio is 0.40. What is its weighted average cost of capital?

(v) Now suppose that the firm has a potential project in which it can invest. The project is
expected to earn cash flows of ✩10,000 over each of the next five years. If this project is of
equal risk with the firm’s current projects, calculate its NPV. Should the firm accept or reject
the proposed project?

(b) Consider a firm with a weighted average cost of capital equal to 12 percent. This firm’s cost of
debt is 10 percent and its cost of equity capital is 16.5 percent. If the corporate tax rate is 35
percent, calculate the firm’s debt-equity ratio.

(c) An all-equity firm is considering the following projects:
Project Beta Expected return
A 0.60 11%
B 0.90 13%
C 1.20 14%
D 1.70 16%

Suppose that the rate of return on T-bills is 6 percent and the expected rate of return on the
S&P500 is 13 percent. Further suppose that the firm has a 12 percent cost of capital

(i) Which projects have a higher expected return than the firm’s cost of capital?

(ii) Which projects should the firm accept (i.e., which projects are positive NPV)?

(iii) Which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital
were used as a hurdle rate?

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2. Answer the following questions pertaining to capital structure.

(a) Consider an all-equity firm with a total market value of ✩150,000. Earnings before interest and
taxes (EBIT) are projected to be ✩14,000 under normal economic circumstances. If the economy
slumps into a receession, EBIT will be 60% lower; if the economy enters a period of expansion,
EBIT will be 35% higher. Each of these scenarios is deemed equally likely. The firm is considering
a plan to issue ✩60,000 in debt with a 5 percent rate of interest and will use the proceeds to
repurchase shares of its stock. There are currently 2,500 shares outstanding. Ignore taxes.

(i) Calculate earnings per share (EPS) under each of these three economic scenarios if the firm
does not go through with the proposed plan.

(ii) Repeat part (i) above assuming that the firm does go through with the proposed plan.

(iii) What do you observe?

(b) Repeat all parts of (a) above assuming that there is a corporate tax rate of 35 percent.

(c) Consider a firm whose equity multiplier is equal to 2.50. Its WACC is 12 percent and its cost of
debt is 14 percent. The firm is in the 35 percent corporate tax bracket.

(i) What is the firm’s cost of equity capital?

(ii) What would be the firm’s cost of capital if it were unlevered?

(iii) What would be the firm’s cost of equity capital if its equity multiplier increased to 3.00?
What if it decreased to 1.00?

(d) Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures (as
their names suggest). Each company expects to earn ✩96 million before interest per year in
perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual
debt has a market value of ✩275 million and the firm pays 8 percent interest on this debt each
year, and it currently has 4.5 million shares outstanding worth ✩100 per share. On the other
hand, Unlevered has no debt and has 10 million shares outstanding worth ✩80 per share. Neither
firm pays taxes. Is Levered’s stock a better buy than Unlevered’s stock?

(e) An all-equity firm is considering a loan of ✩1 million, which it will repay in equal installments over

the next two years at an interest rate of 8 percent. The company’s tax rate is 35 percent. According
to Modigliani-Miller Proposition 1 (with corporate taxes), what would be the increase in the value
of the company after the loan? (Hint: Modigliani-Miller Proposition 1 states VL = VU + tC × B.
We referred to this last term as the “present value of the annual tax shield.”)

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