In the CAPM formula, Beta or ? represent the relative risk of stock which is related to the market. It is a key parameter in the CAPM formula because it will permit to measures the risk of the company compared to the risk of the overall market. The stock risk of the market is representing by a Beta of 1.0 and if the Beta of the company is superior to 1.0 that means that the stock of the company is more risky than the average market and if the Beta is inferior to 1.0 that means that the stock is less risky than the market average. We know that a high beta stock is more risky but could provide a high potential of returns and if the beta is low it is less risky but also with a lower return. Some types of stocks have a high or low beta. For example, luxury's product will have high beta and food's product have a low beta.
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1. CAPITAL ASSET PRICING MODEL
a. Calculate the required return of Stock A.
b. Calculate the Beta of Stock C.
c. Using only Stocks A and D, calculate the percentage of each stock you would need to create a portfolio that has a Beta of 1.0. Calculate the required return of this portfolio.
d. Explain each of the elements of the CAPM formula and answer the following questions:
e. What does Beta mean and how is it determined? Which types of stocks have higher or lower Betas?
f. What does the risk-free rate mean and how is it determined? How could you find today's risk free rate?
g. What does required return mean? Why do we calculate this number?
2. WEIGHTED AVERAGE COST OF CAPITAL
a. Calculate the after-tax cost of debt.
b. Calculate the Weighted Average Cost of Capital (WACC).
c. For any amounts borrowed over $10 million, the bank will increase the interest rate by 2%. The company has three projects and each project costs $10 million. Calculate which of the following three projects the company should pursue:
d. Project A: IRR = 12% Project B: IRR = 16% Project C: IRR = 18%
e. Explain why it is riskier for a company to issue debt instead of equity, and answer the following questions:
f. Which has a lower cost of capital and why: debt or equity?
g. Why would some companies only issue equity?
h. Why would some companies only issue debt?
3. DEBT AND EQUITY FINANCING
a. This company needs to raise additional equity funds for 2012 by selling stock. Calculate how many new shares it would need to issue to have the additional needed equity funds (after paying the investment bankers and paying for its own expenses).
b. Calculate the price at which the corporation should issue each new zero coupon bonds, if it wants to compete with the market rates.
c. Calculate the amount of debt the company needs to issue in 2012 to maintain its same debt ratio from 2011. Include the new stock issued in part a) in your calculations.
d. Discuss the reason that investment bankers will charge much higher flotation costs to issue equity than to issue debt.
e. Discuss the various types of bonds that the company could issue and their advantages and disadvantages.
4. CASH MANAGEMENT
a) Calculate the effective annual interest rate if you do not take the discount from your supplier.
b) Calculate the effective interest rate that this bank is charging you on the loan if it is a discount loan. Should you take the supplier discount offered in part a) then?
c) Calculate the number of days of the Cash Collection Cycle. Assume all sales are for credit, and you do NOT take the discount from your supplier.
d) Describe the role of the Credit Department in an organization and list some of the duties it performs.