Stone Container is a major producer of cardboard boxes. Stone Container has $10M in outstanding equity. In addition, it has $2M in outstanding debt. The debt is a ten-yearmortgage and is rated AAA. This is low risk debt. $2M is both the book and marketvalueof the debt. In addition to its cardboard box production and sales facilities, Stone Containeralso has a portfolio of 3 month government T-bills¹. These are currently worth $3M. Themarket price of risk (e.g. E [rm- rf]) is 8.5 percent.

a)  Stone Container's debt has a β of 0.20. The equity β was estimated using thefollowing equation:

rStoneContainer s equity - rrisk free = 0.0+1.4(rStock market return-rrisk free) + ε

Calculate the β which measures of the risk of Stone Container's assets.

b)  Stone Container is considering expanding its capacity by 15 percent. It will do thisby building a new production facility. It will also expand its sales force by 15% tomarket the additional cardboard boxes. This project will require an investment of$2M. The firm will liquidate part of its T-bill portfolio to pay for the investment.Since Stone Container will lose the 3 percent yield on the bonds, should 3 percentbe the discount rate it uses for evaluating its capacity expansion? Explain briefly.

c)    An alternative method for deriving a discount rate is to use the Capital Asset PricingModel. What discount rate for the capacity expansion investment does CAPMsuggest?²