2. CAPM, , AND FIRM’S RETURN Firm A is a levered with a leverage ratio B/S = 1/2

Question

2. CAPM, , AND FIRM’S RETURN
Firm A is a levered with a leverage ratio B/S = 1/2 where the overall annual borrowing rate of the outstanding debt is 5%. Firm A’s B is estimated to be 1.2 while the yearly stock market expected return is 10% in the future 5 years. The 1-year T-bill is expected to have a yield of 3% in the future 5 years. Also the tax rate to the ?rm is 35%.

(a) What’s the expected return on the stock (equity) using CAPM ?

(b) What’s the weighted average cost of capital of firms A ?   

(c) Assume the firm has an investment opportunity with the total cash flows given below

{- 1000, 500, 600, 800, 700, 400}

What are the NPV and IRR of this project?

(d) Repeat the calculation in last two parts by assuming B/S = 2. Is the same project more profitable under this new leverage ratio?

Explanation / Answer

(a)       Expected return on the stock by using CAPM is as follows.                      Expected return         = Risk free rate +(Risk premium)*Beta of the stock                                                       =      3% + (10%-3%)*1.2                                                       =      3% + 7%*1.2                                                       =      3% + 8.4%                                                       =      11.4%.          Therefore expected return on the stock is 11.4%. (b).             WACC of firm A is calculated as follows.                            =(% of debt)*cost of debt*(1 - Tax bracket) + Cost of equity(% of Equity in capital structure).                            =50%*5%(1 - 35%) + 10%*50%.                            =0.5*5%*0.65 + 0.5%10%                            =1.625% + 5%                            =6.625%.                WACC of firm A is 6.625%. (c)       By using excel spread sheet we can calculate NPV. Inset NPV in formula bar and take the values as follows.                   Value1 = -1000                   Value2 = 500                   Value3 = 600                   Value4 =800                   Value5 =700                   Value6 =400                   Rate      =10%. By enter we can get the answer as 2,227.94 - 1,000.                                              NPV is $1,227.14. (d)             Debt equiry ratio indicates leverage ratio. which is 2. Means for any firm optimal leverage ration is 2:1 is preferrable. No the new project is not profitable under this leverage ratio.

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