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##### ESTIMATING THE COST OF CAPITAL

**Description**

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**Question**

Beta estimation 1. You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns: YEAR R-F RETURN MKT RETURN XYZ RETURN Column5 2007 3% 6% 10% 2008 1% -37% -45% a. What was XYZ's average historical return? b. Compute the market's and XYZ's excess returns for each year. Estimate XYZ's beta. c. Estimate XYZ's historical alpha. d. Suppose the current risk-free rate is 3%, and you expect the market's return to be 8%. Use the CAPM to estimate an expected return for XYZ Corp.'s stock. e. Would you base your estimate of XYZ's equity cost of capital on your answer in part (a) or in part (d)? How does your answer to part (c) affect your estimate? Explain. 15. In mid-2009, Rite Aid had CCC-rated, 6-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%. Suppose the market risk premium is 5% and you believe Rite Aid's bonds have a beta of 0.31. The expected loss rate of these bonds in the event of default is 60%. a. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009? b. In mid-2012, Rite-Aid's bonds had a yield of 8.3%, while similar maturity Treasuries had a yield of 1%. What probability of default would you estimate now? 20. IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business: Debt Outstanding (book value, AA-rated) $400 million Number of shares of common stock 80 million Stock price per share $15.00 Book value of equity per share $6.00 Beta of equity 1.20 Project Risk Characteristics and Financing 23. Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.60, expects to generate free cash flow of $50 million this year, and anticipates a 3% perpetual growth rate. The industrial chemicals division has an asset beta of 1.20, expects to generate free cash flow of $70 million this year, and anticipates a 2% perpetual growth rate. Suppose the risk-free rate is 4% and the market risk premium is 5%. a. Estimate the value of each division. b. Estimate Weston's current equity beta and cost of capital. Is this cost of capital useful for valuing Weston's projects? How is Weston's equity beta likely to change over time? 27. You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 9%. However, the new business will be 25% debt financed, and you anticipate its debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its WACC? NB: Please answer all questions with detailed responses so I can rate you. Thank you. Jan 20 2014 12:34 AM

Solution ID:608970 | This paper was updated on 26-Nov-2015

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