# Week 9

**1) **In a world with no frictions (taxes, etc.), value is created by how you finance a

**2) **The return on equity is equal to the return on assets of a project/firm.

**3) **Suppose the expected returns on equity of two firms, Macrosoft and Microsoft, that operate in the same industry are 10.50% and 12.60%, respectively. What is the return on assets in this business if Macrosoft has no debt? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14).

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**4) **Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14).

**5) **You are planning on opening a consulting firm. You have projected yearly cash flows of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is 10%. The risk-free rate is 3.25% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. What is the value of the cash flows of your business?

18099548.

20060181.

**6) **Your firm has been plodding along without much attention from the stock market; both analysts and investors are not showing much interest in your company. Your boss insists that (a) he can increase the return on equity of the company by simply taking on more debt and (b) that will attract new investors to the firm because of the higher returns.

**7) **Two firms, ABC, Inc., and XYZ, Inc., are in the same business. XYZ, Inc., has debt that is viewed by the market as risk-less with a market value of $250 million. ABC, Inc., has no debt. Both firms are expected to generate cash flows of $50 million per year for the foreseeable future and the market value of the equity of ABC, Inc is $500 million. Estimate the return on equity of XYZ, Inc. Assume there are no taxes, and the risk-free rate is 4%. (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

**8) **Banana, Inc. has had debt with market value of $0.5 million that has paid a 5% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $1 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 10%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)

**9) **Suppose all investors are risk-averse and hold diversified portfolios. You are evaluating a new drug company that is going to have two divisions: an R&D unit and a Sales unit. Your CEO and you are arguing about whether the two units should have the same cost of capital (WACC), or whether the discount rates should be different. If different, what should be the relative magnitudes of the discount rates, that is, which unit R&D or Sales should have the higher discount rate. Assume the discount rates of the two units are labeled as R (for R&D) and S (for Sales), respectively. What do you think?

S>R.

The same discount rates for both divisions/units (R=S).

R>S.

**10) **AmRail has been granted permission to transport passengers between major U.S. cities. The new company faces competition from regional railway companies that operate between major cities in their regions. The betas of the equity of the four major competitors (A, B, C, D) are 1.10, 1.20, 1.30, and 1.40; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.10, 0.20, 0.30, 0.40. Although these D/E ratios vary, all debt is considered risk-free in the market place because railways are expected to dominate all long-distance public transportation. Suppose the expected market risk premium (the average difference between the market return and the risk-free rate) is 5% and the risk free rate is 4%. What is the cost of capital (or discount rate) that you should use in valuing AmRail? Assume there are no taxes. (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

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