- Explain the difference between unique risk and market risk. When you diversify your portfolio by making investments across many different assets, which risk can be eliminated?
- Explain the risk aversion and the market risk premium.
- How does a bond’s call provision protect its issuer against market interest rate changes?
- Consider the following stock valuation models.
- During the last year, Blue Bell Inc. has been too constrained by the high cost of capital to make capital investments. Recently, though, capital costs have been declining, and the firm has decided to look seriously at a major expansion program. Joe Smith who is a financial manager is asked to estimate Blue Bell’s cost of capital. The following information is provided.
Constant growth model
Non-constant growth model
Free cash flow stock valuation model
Explain each model’s assumptions and appropriateness.
The firm’s tax rate is 35%.
The firm has 7% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $968.55. The bond’s yield-to-maturity is 7.35%.
The firm’s balance sheet shows $100 million long-term debt and $300 million common equity. The firm has no preferred stock.
Joe estimates a 12.6% of the cost of common stock using the CAPM and calculates the firm’s weighted average cost of capital (WACC) as follows:
Weight of long-term debt is .25 (=100/400)
Weight of common equity is .75 (=300/400)
WACC = .25 x 7% x (1 – .35) + .75 x 12.6% = 13.05%
- Find errors in Joe’s WACC calculation.
- If the firm is considering a project whose risk is quite different from the firm’s average risk, is the firm’s WACC still useful for evaluating this project? What does the manager have to do in order to correctly evaluate this project?
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