1. If a company uses its cost of capital to evaluate all projects. Will it under

Question

1. If a company uses its cost of capital to evaluate all projects. Will it underestimate or overestimate the value of low-risk projects?

2. A company is 60% financed by risk-free debt. The interest rate is 12%, the expected market risk premium is 9%, and the beta of the company’s common stock is 0.6. What is the company’s cost of capital?

3. Monkey’s Toy is 40% financed with long term bonds and 60% with common equity. The debt securities have a beta of 0.2. The company’s equity beta is 2.15. What is Monkey’s Toy’s asset beta?

Explanation / Answer

1. It will underestimate. Low-risk project will have lower interest rate compared to cost of capital. So, cost of capital being higher than necessary, the project will be underestimated. 2. Expected return on equity, r(m) = r(f) +b*r(p) => r(f) = r(m) -b*r(p) = 12 - 0.6*9 = 6.6% debt rate Rd = 6.6% equity rate Re = 12% Wd = 0.60 We = 0.40 WACC = We*Re + Wd*Rd = 0.40*12 + 0.60*6.6 = 8.76% (ANSWER) 3 We presume r(f) =6.6%, and r(p) = 9%, from 2. above. Rd = 6.6+0.2*9 = 8.4% Re = 6.6+2.15*9 = 25.95% WACC = 0.60*25.95 + 0.40*8.4 = 18.93% (ANSWER)

Related Questions

Navigate

• Browse (All)
• Browse 1
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.