Determine the cost of equity based on capm

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Reference no: EM135318

Q1. Suppose that you have been hired as a consultant by Denver Printing, Inc. to assist the firm to make decision on the investment.  The balance sheet and some other information are given below:


Current assets

$ 38,000,000

Net plant, property, and equipment


Total assets                                                 

Liabilities and Equity


Accounts payable

$ 10,000,000



Current liabilities

$ 19,000,000

Long-term debt (40,000 bonds, $1,000 par value)


Total liabilities

$ 59,000,000

Common stock (10,000,000 shares)


Retained earnings


Total shareholders' equity


Total liabilities and shareholders' equity


The stock is presently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00 (suppose that this firm has only one class of bond, in other words, all of 40,000 bonds outstanding has the same characteristics as explained).  The beta is 1.25, and the yield on a 20-year Treasury bond is 5.50%.  The needed return on the stock market is 11.50.  The firm's tax rate is 40%.

Denver Printing is allowing for purchasing a new printing machine that is expected to help the firm reduce labor costs.  Denver Printing expects that this new machine may reduce its pre-tax labor costs by $60,000 in the first year.  Each year after that, it is expected that there may be 2% increase in reduction of pre-tax costs.  Thus, Denver Printing does not expect the revenue to change due to this new machine.  No change in net operating working capital is expected with this new machine.  The base price of this new machine is $120,000, and installation and shipping costs would add another $12,500. The machine falls into the MACRS 3-year class, and is expected to be used for 3 years and replacement may be sought as the machine will be scrapped, but the firm does not have any information about the future other than this new machine.  The marginal tax rate for the firm is 40%.

a. Evaluate the after-tax cost of debt?

b. Determine the cost of equity based on CAPM?

c. Compute the firm's WACC?

d. Estimate the cash flow for each year of this project

e. Evaluate the NPV of the project?  Based on this NPV, should the firm invest in this project?

f. Calculate the IRR of this project?  Based on this IRR, should the firm invest in this project?

Q2. You have a project available to you.  It is a 20-year investment that pays you $100 at year 1, $500 at year 2, $750 at year 3, and some fixed cash flow, X, at the end of each of the remaining 17 years.  The price of this investment is $5,000. The discount rate for this investment is 9% given its risk.  If the NPV of this project is $544.87, what is the annual cash flow received at the end of each of the final 17 years, that is, what is X?

Q3. Micro Inc. is expanding quickly.  Because it requires to retain all of its earnings, it does not presently pay any dividends.  Investors expect that Micro to begin paying dividends finally, with the first dividend of $1.00 coming three years from today. The dividend should grow rapidly at a rate of 50 percent per year during Years 4 and 5.  After Year 5, the company should grow at a constant rate of 8% per year.  If the needed rate of return on the stock is 15 percent, what is the value of this stock today?

The question:

Explain the ideas of specific risk, systematic risk, variance, standard deviation, covariance, and beta as they relate to investment management.

Please don't turn this question into a "core dump."  You should be able to describe each individual concept in a sentence or two.  Then take a paragraph to relate them to each other (where applicable) and to investment management.

Reference no: EM135318


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