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Chapter 4 Solutions (Finance) Essay

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Chapter 4 4-1 a. We use the CAPM: The Expected Return on the stock = 0.058 + 0.95(0.0876) = 0.1412 = 14.12%. Since the investor is a short-term investor, we use the T-bill rate, and the arithmetic mean. Since the focus is short-term, we don’t need to take compounding into account. b. For a long-term investor, we would use the T-bond rate, and the geometric mean: The expected return = 0.064 + 0.95(0.0561) = 0.1173 or 11.73%, where 5.61% is used as the estimate of the market risk premium, since that is the geometric average of the market premium using the long-term T-bond rate as the riskfree rate. If we use 5.5% as our estimate of the market premium, the expected return would be 0.064 + 0.95(0.055) = 0.1163 or 11.63%. c. The cost of equity for the company is more appropriately the long-term required rate of return, since most projects for the company would be long-term. 4-2 a. The levered beta of the company is given by formula: . Solving, we get βunlevered = 0.95/(1+(1-0.36)(1.7/1.5)) = 0.55 b. The proportion of the risk of the firm’s equity that can be attributed to business risk is 0.55/0.95 = 58%, while the remainder is due to financial leverage risk. 4-3 a.The cost of equity equals 0.064 + 1.70(0.055) = 15.75% b. If long term bond rates rise to 7.5%, the cost of equity will rise by a like amount to 16.85%. c. Since Biogen had no debt, all of its risk is due to business risk. 4-4 a. The expected return on the stock, assuming that the marginal investor is a Malaysian with primarily domestic holdings is 0.115 + 1.15(0.12) = 25.30%, using the risk premium based on country risk provided by ratings agencies. b. For an international investor, who has the ability to diversify globally, some of the risk might be diversifiable, and hence the true beta might be lower. To take care of this possible overstatement, it would be appropriate to compute a beta relative to a more global index, such as the Morgan Stanley Capital Index. 4-5 a. Using the CAPM, we compute the...

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