kim226

A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to:

A) 1.071.

B) 0.832.

C) 0.632.

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The unlevered beta for this company is calculated as:

kim226

Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence’s capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this project is closest to:

A) 0.38.

B) 0.58.

C) 1.18.

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The unlevered asset beta is:

Affluence’s debt-to-equity ratio = 0.75/0.25 = 3. To calculate the project beta, re-lever the asset beta using Affluence’s debt-to-equity ratio and marginal tax rate:

kim226

Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the proposed BioChem product line expansion. The beta of the proposed project is estimated from the beta of that firm after appropriate adjustments for capital structure differences. The method that Costa uses is known as the:

A) build-up method.

B) pure-play method.

C) accounting method.

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The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta, unlevering it using the pure-play company’s capital structure, and re-levering using the subject company’s capital structure.

kim226

Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services company based in the U.S. Stolzenbach’s management team is considering opening new stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach’s investment in Mexico. Winfield has researched bond yields in Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All Share Index stock index and the S&P 500 index was 38% and 20% respectively. The annualized standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was 26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the cost of equity that Winfield should use in his analysis?

Country Risk Premium for Mexico

Cost of Equity for Project

A) 4.53% 17.36%

B) 5.89% 17.36%

C) 4.53% 19.06%

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.077 – 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%

Cost of equity = RF + β[E(RMKT) – RF + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36% Note that you are given the market risk premium, which equals E(RMKT) – RF.

kim226

Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis:  

• Indian 10-year government bond yield = 7.20%
• 10-year U.S. Treasury bond yield = 4.60%
• Annualized standard deviation of the Bombay Sensex stock index = 40%.
• Annualized standard deviation of Indian dollar denominated 10-year government bond = 24%
• Annualized standard deviation of the S&P 500 Index = 18%.

The estimated country risk premium for India based on Marian’s research is closest to:

A) 2.6%.

B) 4.3%.

C) 5.8%.

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

kim226

In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A) use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B) add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

C) add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

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In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

kim226

Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $199	4.5%	$0 to $299	7.5%
$200 to $399	5.0%	$300 to $699	8.5%
$400 to $599	5.5%	$700 to $999	9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both:

A) $500 million and $700 million.

B) $400 million and $700 million.

C) $500 million and $1,000 million.

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Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints.
Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million
Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million
Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million
Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million

kim226

Simcox Financial is considering raising additional capital to finance a takeover of one of the firm’s major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $149	4.2%	$0 to $399	7.5%
$150 to $349	5.0%	$400 to $799	8.5%

Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively?

Breakpoint for new debt capital

Breakpoint for new equity capital

A) $428.6 million $533.3 million

B) $428.6 million $615.4 million

C) $375.0 million $615.4 million

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A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.

kim226

Which one of the following statements about the marginal cost of capital (MCC) is most accurate?

A) The MCC is the cost of the last dollar obtained from bondholders.

B) A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.

C) The MCC falls as more and more capital is raised in a given period.

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A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure.
The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.

kim226

A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate?

A) An increase in the after-tax cost of debt may occur at a break point.

B) A project’s internal rate of return decreases when a breakpoint is reached.

C) Any given project’s NPV will decline when a breakpoint is reached.

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The internal rate of return is independent of the firm’s cost of capital. It is a function of the amount and timing of a project’s cash flows.