1. In Chapter 8 Figure 8.1 (known as the market line or the risk return trade of

Question

1. In Chapter 8 Figure 8.1 (known as the market line or the risk return trade off line) why should a company reject investment opportunities lying below the market line and accept those lying above the market line ?

2. How will an increase in financial leverage affect a company's cost of equity capital ? How will it affect a company's beta equity ?

3. Waste Management's annual dividend is $1.50 / share and its current stock price is $44.50. Assuming a 4% annual growth rate in dividends, what is Waste Management's cost of equity ?

4. The Coca-Cola Company's beta is 0.73.  The long-term government bond rate is 2.0%. Assuming 6.3% for the historical excess return on common stocks, what is Coca-Cola's cost of equity capital ?

Explanation / Answer

1. When an investment is below the market line, it is possible to make an investment of equal-risk with the promise of higher returns. Also investments above the market line can be made with expected returns above those available with equal-risk.

2. The increase of financial leverage increases the risks associate with equity investors and consequently increases the cost of equity capital. The company’s equity beta will increase also. The increase of the equity beta will result in the increase of the cost of equity.  

3. Cost of Equity = (Dividend per Share/ Current Market value of Share) + Growth Rate of Dividend

Cost of Equity = ($1.50/$44.50) +4

= 4.033

4. Cost of Equity Capital

Es = Rf + Beta (Risk Premium)

= 2 + 0.73 *6.3

= 6.599 %

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