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Penn State - RUS 100 - Beta and the Cost of Equity 12 - Study Guide

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Penn State - RUS 100 - Beta and the Cost of Equity 12 - Study Guide

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background image Beta and the Cost of Equity 12.1 Furniture Depot, Inc., is an all-equity firm with a beta of 0.95.  The market risk premium is nine 
percent and the risk-free rate is five percent.  The company is considering a project that will 
generate annual after-tax cash flows of $340,000 at year-end for five years.  The project requires 
an immediate investment of $1.2 million.  If the project has the same risk as the firm as a whole, 
should Furniture Depot undertake the project?
12.2 The returns for the past five years on Douglas stock and the New York Stock Exchange Composite
Index (NYSE) are listed below:
Douglas NYSE -0.05 -0.12 0.05 0.01 0.08 0.06 0.15 0.10 0.10 0.05 a. What are the average returns on Douglas stock and on the market? b. Compute the beta of Douglas stock. 12.3 The correlation between the returns on Ceramics Craftsman, Inc., and the returns on the S&P 500 
is 0.675.  The variance of the returns on Ceramics Craftsman, Inc., is 0.004225, and the variance 
of the returns on the S&P 500 is 0.001467.  What is the beta of Ceramics Craftsman stock?
12.4 The returns from the past 13 quarters on Mercantile Bank Corporation and the market are listed 
below.  
Mercantile Market -0.009 0.023 0.051 0.058 -0.001 -0.020 -0.045 -0.050 0.085 0.071 0.000 0.012 -0.080 -0.075 0.020 0.050 0.125 0.120 0.110 0.049 -0.100 -0.030 0.040 0.028 The covariance of Mercantile Bank Corporation’s return with the market’s return is 0.038711.  The
market variance is 0.038588.  The expected returns on Mercantile and the market are 0.016333 
and 0.019667, respectively.  
a. What is the beta of Mercantile Bank Corporation stock? b. Is Mercantile’s beta higher or lower than the beta of the average stock? Copyright 2003, McGraw-Hill.  All rights reserved.
background image 12.5 The following table lists possible rates of return on two risky assets, L and J.  The table also lists 
their joint probabilities, that is, the probabilities that the two observations will occur 
simultaneously.  
a. List the possible values for R L  and the probabilities that correspond to those values.   b. Compute the following items for R L . i. Expected value ii. Variance iii. Standard deviation c. List the possible values for R J  and the probabilities that correspond to those values.   d. Compute the following items for R J . i. Expected value ii. Variance iii. Standard deviation e. Calculate the covariance and correlation coefficient of R L  and R J . f. Assume L is the market portfolio.  Calculate the beta coefficient for security J.   12.6 If you use the stock beta and the security market line to compute the discount rate for a project, 
what assumptions are you implicitly making?
12.7 Jang Cosmetics is evaluating a project to produce a perfume line.  Jang currently produces no 
body-scent products and is an all-equity firm. 
a. Should Jang Cosmetics use its stock beta to evaluate the project? b. How should Jang Cosmetics compute the appropriate beta to evaluate the project? 12.8 The following table lists possible rates of return on Compton Technology’s stock and debt, and on 
the market portfolio.  The probability of each state is also listed.  
State Probability Return on Stock (%) Return on Debt (%) Return on the Market (%) 1 0.1       3%      8%      5% 2 0.3   8   8 10 3 0.4 20 10 15 4 0.2 15 10 20 a. What is the beta of Compton Technology debt? b. What is the beta of Compton Technology stock? c. If the debt-to-equity ratio of Compton Technology is 0.5, what is the asset beta of 
Compton Technology?  Assume no taxes.  
12.9 Consider a levered firm’s projects that have similar risks to the firm as a whole.  Is the discount 
rate for the projects higher or lower than the rate computed using the security market line?  Why?  
Copyright 2003, McGraw-Hill.  All rights reserved. R L R J Prob(R L , R J ) 0.16 0.16 0.10 0.16 0.18 0.06 0.16 0.22 0.04 0.18 0.18 0.12 0.18 0.20 0.36 0.18 0.22 0.12 0.20 0.18 0.02 0.20 0.20 0.04 0.20 0.22 0.04 0.20 0.24 0.10

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School: Pennsylvania State University
Department: Russian
Course: Corporate Finance
Term: Spring 2014
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Description: Beta and the Cost of Equity 12
Uploaded: 07/08/2017
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