Assume you are the president of a large investment banking firm. On a whim, you...
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Assume you are the president of a large investment banking firm. On a whim, you decide to buy a company named West Coast Body Art. The company is the largest manufacturer of clip-on nose and eyebrow rings in the US.
You have determined that West Coast Body Art is likely to generate a perpetual annual cash flow of $1,000,000. You estimate the firm CAPM beta to be 0.5, but the true beta is really 1.0. Assume the risk free rate is 6%, and the expected return on the market is 16%. Assume the firm pays no taxes. If you rely on your CAPM beta estimate of 0.5, how much more will you pay for the firm than it is truly worth? (Hint: Since the annual cash flow is a perpetuity, the value of the firm = P/k).
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