Concept Checks

4.1: can be either, depending upon whether the prediction is short-term or long-term
If the analysis is long term, I would use the long term rate. If it is short term, I would use the short-term rate

4.2: Between 10.7-12.7%
There is no right answer here. This is a reflection of your risk aversion; the more risk averse you are, the higher your premium will be.

4.3: be higher
Again, there is no right answer. Given my risk aversion, however, I would demand a larger premium.

4.4: to find more overvalued stocks than undervalued ones
Using a larger premium results in higher discount rates and lower values across the board for all investments.

4.5: I would be indifferent, because they have the same beta
I am well diversified, and thus can eliminate all firm-specific risk. If I were not, I would have picked Disney, since it has less firm-specific risk.

4.6: Pepsico, because it will go into other businesses over time.
Going into other businesses will result in a more diversified firm with a beta closer to one.

4.7: greater than one
Polo's products are expensive and discretionary.

4.8: The European firms will have much higher betas than the U.S. firms
The higher fixed costs (due to social structure) will increase the operating leverage at these firms and make their earnings more volatile. This will ultimately show up in the betas.

4.9: No
When interest rates go down, both the cost of debt and the cost of equity (the riskless rate component in the CAPM) will go down.

4.10: No
Equity investors are always behind lenders in the line for cash flows (on an annual basis) and for assets (on liquidation). They should therefore demand a higher return.

4.11: Preferred stock is treated as equity by the ratings agencies and regulators
Thus, firms may be able to operate with fewer constraints if they issue preferred stock. This rationale makes more sense for regulated firms (such as banks).

4.12: The equity component of the convertible bond will increase as a percentage of the total value
As the stock price goes up, the conversion option will increase in dollar value. Even though the straight bond portion may not lose value, equity as a proportion of total value will go up.