turtle5a1 Posts: 18, Reputation: 1 New Member #1 Jan 8, 2010, 05:52 AM
Corporate Finance
Hi guys I have a question on Corporate Finance that I need help badly. Advice. Thanks.

Here's the question:

You are given the following information about the stock market and 3 companies A, B, C. For the next period the return on the market portfolio is 11% and the riskless rate is 3%. Company A is financed by 2/3 equity and 1/3 debt. Company's A equity has a beta of 1.5, its debts have a beta of 0.4. Companies B and C are both 100% equity financed with respective beta of 1.2 and 0.7, and respective returns of 13.5% and 8.6%.

1. Calculate the average cost of capital and asset beta for company A?

3. Separately compute the mix of A and C equity shares in a portfolio and the mix of B and C equity shares in a portfolio which would each give a 10% return?

For the first part when they ask about the average cost of capital how do we calculate and I have no issue on the beta. As for the third part what are they asking for I don't understand at all. Assist. Thanks.
 ArcSine Posts: 969, Reputation: 106 Senior Member #2 Jan 8, 2010, 06:51 AM
This'll get you rolling in the right direction...

Right away you're given that the market risk premium is 8%, which is the excess of the market's return over the risk-free rate.

The beta term--as a multiplier--gives you the risk premium that's specific to a particular stock or instrument, relative to the market's risk premium. E.g. Co A's equity has a beta of 1.5, which means that Co A's equity has a risk premium of 1.5 x 8% = 12%. Add that risk premium to the risk-free rate to arrive at Co A's equity's expected return, aka 'cost of capital'.

Do likewise for A's debt to arrive at the debt's cost of capital. Finally, A's average COC is just the weighted average of the two specific capital costs--i.e. the specific COC for its equity, and for its debt. The weights you'll use in this averaging is the 2/3 -- 1/3 proportions that equity and debt represent in A's capital structure, respectively.

Answering the second question also involves a weighted average calculation. To illustrate, if I have half of my portfolio in a stock with an expected return of 8%, and the other half in a stock with an expectation of 14%, my overall portfolio has a weighted-average expected return of 11%.

Hope that helped out a bit.
 turtle5a1 Posts: 18, Reputation: 1 New Member #3 Jan 13, 2010, 01:47 AM

Thanks a lot... I think I understand already

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