principles of corporate finance chapter 9

1. Suppose a firm uses its company cost of capital to evaluateall projects. Will it underestimate or overestimate the value ofhigh-risk projects?

2. A company is 40% financed by risk-free debt. The interestrate is 10%, the expected market risk premium is 8%, and the betaof the company’s common stock is .5. What is the company cost ofcapital? What is the after-tax WACC, assuming that the company paystax at a 35% rate?

4. Define the following terms: a. Cost of debt b. Cost of equityc. After-tax WACC d. Equity beta e. Asset beta f. Pure-playcomparable g. Certainty equivalent

5. Asset betas EZCUBE Corp. is 50% financed with long-term bondsand 50% with common equity. The debt securities have a beta of .15.The company’s equity beta is 1.25. What is EZCUBE’s asset beta?

9. True or false?

a. The company cost of capital is the correct discount rate forall projects because the high risks of some projects are offset bythe low risk of other projects.

b. Distant cash flows are riskier than near-term cash flows.Therefore long-term projects require higher risk-adjusted discountrates.

c. Adding fudge factors to discount rates undervalues long-livedprojects compared with quick-payoff projects.

10. A project has a forecasted cash flow of $110 in year 1 and$121 in year 2. The interest rate is 5%, the estimated risk premiumon the market is 10%, and the project has a beta of .5. If you usea constant risk-adjusted discount rate, what is a. The PV of theproject? b. The certainty-equivalent cash flow in year 1 and year2? c. The ratio of the certainty-equivalent cash flows to theexpected cash flows in years 1 and 2?

12. Nero Violins has the following capital structure:

security	beat	total market value(sillions)
debt	0	100
preferred stock	0.2	40
common stock	1.2	299

a. What is the firm’s asset beta? (Hint: What is the beta of aportfolio of all the firm’s securities?) b. Assume that the CAPM iscorrect. What discount rate should Nero set for investments thatexpand the scale of its operations without changing its asset beta?Assume a risk-free interest rate of 5% and a market risk premium of6%.

16. What types of firms need to estimate industry asset betas?How would such a firm make the estimate? Describe the process stepby step.

17. Binomial Tree Farm’s financing includes $5 million of bankloans. Its common equity is shown in Binomial’s Annual Report at$6.67 million. It has 500,000 shares of common stock outstanding,which trade on the Wichita Stock Exchange at $18 per share. Whatdebt ratio should Binomial use to calculate its WACC or asset beta?Explain.