Questions and problems for "Capital Budgeting and Investment Analysis" by Alan C. Shapiro
#1. A corporation's securities have the following betas and market values:
Beta Market Value
Debt 0.1 100,000
Preferred 0.4 200,000
Common 1.5 100,000
Calculate the following figures given a riskless interest rate of 10% and market risk premium of 5%
a. Discount rates for each security
b. The asset beta for the corporation
c. The weighted average cost of capital
d. The discount rate for the unlevered assets
# 2. A corporation has the following balance sheet (liabilities side):
Current Liabilities $ 2,000
Long-Term Debt 5,000
Preferred Stock 2,000
Common Stock 8,000
Retained Earnings 3,000
$20,000
Currently, the riskless interest rate is 8%; the corporate tax rate is 50%; the current price of a share of common stock is $20; and dividends have been level at $1 per share per year for many years.
Recently, company executives have considered expanding the existing business by acquiring a competitor. To do so, they must calculate the WACC of the firm and estimate the NPV of the acquisition. Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.
A financial executive has used the following procedure to calculate the WACC. Debt and preferred stock are fixed claims offering a fairly secure constant return, and so there before-tax cost is assumed to equal the riskless rate. The dividend yield has held constant at about 5%; so this is used as the cost of new and retained equity. Finally, the balance sheet shows the firm to be composed of 25% debt, 10% preferred, 55% equity (common plus retained), and 10% current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55%. Comment on this procedure.
#3. A large food processor and distributor is considering expansion into a chain of privately owned sports shoe outlets. The food company wishes to estimate the risky discount rate for such investments so as to negotiate a fair price for the acquisition. Unfortunately, there are no stock exchange-listed sports shoe companies with a price history with which a "sports shoe outlet beta" can be estimated. However, executives are considering using the price history of another company to estimate the beta. Which of the following companies would be most appropriate? Explain.
a. Another large food company
b. A holding company for a football team.
c. A company that manufactures shoes
d. A Chain of swimwear and surfboard stores in California
#4. One of the more successful strategies in retailing has been the development of "designer label" lines of apparel. In what ways does a designer suit differ from its equivalent purchased from a discount chain? Is this the result of advertising, quality, or some other factors?
#5. Suppose a capital goods manufacturer brings out a new, more efficient machine.
a. If the manufacturer holds a patent on this machine, who is likely to benefit the most from it? Explain.
b. Who will benefit most from the machine if the technology underlying the machine is not proprietary? Explain.
c. What are some of the things the manufacturer can do to earn higher returns from this machine even without patent protection?