Problems and Questions
1. Examine the following sources of risk, and list out whether you would consider them as part of an investment analysis if you were a large publicly traded clothing retail firm:
a. The project analyst might have over estimated the revenues on the store.
b. There might be a natural disaster (hurricane or flood) in the area where the project is located, resulting in major losses.
c A competitor might open a store close by and drive down margins and sales.
d. A manufacturing plant that employs most of the people who live in the area around the store might close down.
e. An economic recession leads to layoffs at the plant resulting in lower sales and profits at the store.
f. A national sales tax might be passed decreasing sales.
g. Inflation increases, increasing interest rates.
2. Would any of your answers be different if you were a small private company considering a similar store opening?
3. The Limited is considering expanding into South America. In making its project analyses, the following information is available:
a. Estimate the cost of equity to use in evaluating the new South American stores.
b. Explain your reasoning and the conditions under which you might have decided differently.
4. You have been asked to estimate the cost of capital for a power plant being considered in Thailand by a U.S.-based utility. The plant will require an initial investment of $ 1 billion and will be independently financed using 60% debt (carrying an after-tax rate of 4.5%) and 40% equity. The beta for power plants is expected to be 0.8, and the treasury bond rate is 7%.
a. Estimate the cost of equity for this power plant, in U.S. dollars.
b. Estimate the cost of capital for this power plant, in U.S. dollars.
c. How would your analysis differ, if it were done in the local currency.
5. You are advising a phone company that is planning to invest in projects in multimedia. The beta for the telephone company is 0.75 and has a debt/equity ratio of 1.00; the after-tax cost of borrowing is 4.25%. The multimedia business is considered to be much riskier than the phone business; the average beta for comparable firms is 1.30, and the average debt/equity ratio is 50%. Assuming that the tax rate is 40%:
a. Estimate the unlevered beta of being in the multimedia business.
b. Estimate the beta and cost of capital if the phone company finances its multimedia projects with the same debt/equity ratio as the rest of its business.
c. Assume that a multimedia division is created to take these projects, with a debt/equity ratio of 40%. Estimate the beta and cost of capital for the projects with this arrangement.
6. Intel is exploring a joint venture with Ford to develop computer chips to use in automobiles. While Intel had traditionally used a cost of equity based upon its beta of 1.50, and a cost of capital based upon its debt ratio of 5%, it is examining whether it should use a different approach for this project. It has collected the following information ñ
a. Estimate the beta that Intel should use for this project.
b. Estimate the cost of capital that Intel should use for this project.
c. What would the consequences be of Intel using its current cost of equity and capital on this project?
7. Hersheyís, the chocolate manufacturer, is considering expanding its operations into Malaysia. It is trying to estimate the appropriate cost of capital to use in evaluating this expansion option and has collected the following information ñ
a. Estimate the cost of capital, in U.S. dollars, for this project, if the treasury bond rate is 7.5%?
b. Did you charge a premium for currency risk? Why or why not?
c. Did you charge a premium for political risk? Why or why not?
d. Would your analysis have been any different if Hershey was privately held?
8. You are analyzing a line of cosmetics that The Gap is proposing to introduce, and are trying to arrive at a reasonable estimate for the cost of equity for this project. The Gap has no debt and a beta of 1.45. In contrast, cosmetics firms have an average beta of 1.75 and an average debt/equity ratio of 10%. The treasury bond rate is 7%, and the corporate tax rate is 40%. What would your estimate of cost of equity be for this project and why?
9. Returning to the cosmetics project example for The Gap, assume that you have the following estimates of the cash flows on the project ñ
Year After-tax Cash Flows (to Equity)
0 - 10,000,000
1 + 3,500,000
2 + 4,000,000
3 + 4,500,000
4 $ 5,000,000
5 $ 5,000,000
The project ends after five years and there is no salvage value.
a. Estimate the net present value of the project, using the cost of equity estimated in the previous problem.
b. Estimate the certainty equivalent cash flows in each year, and the net present value based upon these certainty equivalents.
10. The New York Yankees, the baseball franchise, is considering introducing a new line of clothes with the Yankee logo on them. The Yankees are a privately owned firm, and therefore have no risk parameters estimated for them. Publicly traded firms involved in the apparel business have an average beta of 1.15, and an average debt/equity ratio of 20%. The treasury bond rate is 7%, and the corporate tax rate is 40%.
a. Estimate the beta and cost of equity for this project.
b. Should there be a premium for the fact that Yankees are a privately owned business? Why or why not?
11. You are helping the financial managers of a grocery store estimate a cost of capital to use in assessing new stores. The grocery store, which is publicly traded, has a beta of 1.40, and a debt/equity ratio of 70%; the after-tax cost of debt is 5.5%. The managers are trying to estimate costs of capital at two different stores. One is a suburban store, with little competition, and where the cash flows can be estimated fairly accurately. The other is a store in New York City, where the estimates have much more potential for error.
a. What cost of capital would you charge for these two stores?
b. Would you charge a higher cost of capital for the New York City store? Why or why not?
12. Compaq is trying to estimate a cost of capital to use in assessing its entry into the high-end workstation market. The publicly traded firms, in this market, have an average beta of 1.20 and an average debt/equity ratio of 20%. There is intense competition within the industry for business. Compaq itself has a beta of 1.45 and carries a debt ratio of only 10%. It plans to maintain this debt ratio on its new venture.
a. Estimate the cost of capital for this new venture.
b. Would you charge a premium for the fact that this is an intensively competitive industry? Why or why not?
13. Philip Morris is reexamining the costs of equity and capital it uses to decide on investments in its two primary businesses - food and tobacco. It has collected the following information on each business.
Philip Morris has a beta of 0.95 and a debt ratio of 25%; the pre-tax cost of debt is 8%. The treasury bond rate is 7%, and the corporate tax rate is 40%.
a. Estimate the cost of capital for the tobacco business.
b. Estimate the cost of capital for the food business.
c. Estimate the cost of capital for Philip Morris, as a firm.
14. Having looked at your estimates of cost of capital for the tobacco and food divisions at Philip Morris, the financial managers at Philip Morris have come back with a question. Where, they want to know, is the substantial risk posed by tobacco lawsuits showing up in the costs of capital that you have estimated? Respond.
15. Now assume that Philip Morris is considering separating into two companies - one holding the tobacco business and one the food business.
a. Assuming that the debt is allocated to both companies in proportion to the market values of the divisions, estimate the cost of capital for each of the companies. Will it be the same as the costs of capital calculated for the divisions? Why or why not?
b. Assuming that the tobacco firm is assigned all of the debt and that both firms are of equal market value, estimate the cost of capital for each company? (Assume that the pre-tax cost of debt will increase to 10%, if this allocation is made.)
16. You are assisting First Global, an international bank, decide on the costs of equity it should be using to evaluate its various divisions. It has 3 divisions currently ñ commercial banking, real estate and investment banking. The betas of comparable firms in each division are provided below ñ
Division Comparable Firmsí Beta
Commercial Banking 1.05
Real Estate 0.70
Investment Banking 1.40
a. Estimate the costs of equity for each division.
b. What would happen if you used First Globalís beta of 0.95 to
estimate the cost of equity for all three divisions?