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Question

"font-size:12pt;line-height:115%;font-family:'Times New Roman';">1.

"font-size:12pt;line-height:115%;font-family:'Times New Roman';">You

are considering acquiring a firm that you believe can generate

expected cash flow of $50,000 a year forever

"font-size:12pt;line-height:115%;font-family:'Times New Roman';">a.

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"font-size:12pt;line-height:115%;font-family:'Times New Roman';">a.

"font-size:12pt;line-height:115%;font-family:'Times New Roman';">the

beta of the firm is predicted to be 0.6. How much is the firm worth

if the risk free rate is 7% and expected rate of return on the

market portfolio is 13%?

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b.How much will the firm be undervalued if the beta ends up being

0.45?

Explanation / Answer

a. Discount rate = rf+ beta*(rm-rf) = 7% +0.6*(13%-7%) = 10.6%

firm worth = 50000/10.6% = $471698.11

b. New Discount rate = rf+ beta*(rm-rf) = 7% +0.45*(13%-7%) = 9.7%

New firm worth = 50000/9.7% = $515463.92

The firm is undervalued by = 515463.92-471698.11 = $43765.80

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