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Practice problem--it's very helpful ~

2 Pages
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Department
Economics
Course Code
ECO359H5
Professor
Sun

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ECO359/2011UniversityofToronto
PracticeProblems  DepartmentofEconomics
1
ECO 359 Practice Problems 2 – Solution Guidelines
1.
(a) Project A.
(b) NPV of A is N $669, NPV of B is N $751.
(c) For (a): interim cash flows can be reinvested at the respective IRR. For (b): they can be
reinvested at the required rate of return r = 10%.
2. The discount rate for the project is equal to the expected return for the security, RS, since the
project has the same risk as the firm as a whole. Apply the CAPM to express the firm’s
required return, RS, in terms of the firm’s beta, Ú, the risk-free rate, RF, and the expected
market return, 4
$Æ.
4ÌL4
¿EÚH:4
$ÆF4
¿;Lrärw Erä{w Hrär{ Lsuäww¨
Calculate the NPV of the cash inflows, using 13.55%. as the discounted rate:
028 LFEJPE=HEJRAOPIAJP EÍ%(ç
:sEN;ç
Í
ç@5
L FDsátrrárrr EÍDuvárrr
:sEsuäww¨;ç
9
ç@5
L FDsátrrárrr EDsásy{á{zuävz L FDtrársxäwt Or
Do not undertake the project since the NPV is negative.
3. The discount rate for the projects should be lower than the rate implied by the security market
line. The security market line is used to calculate the cost of equity. The appropriate discount
rate for projects is the firm’s weighted average cost of capital. Since the firm’s cost of debt is
generally less that the firm’s cost of equity, the rate implied by the security market line will be
too high.
4. Beta measures the responsiveness of a security's returns to movements in the market. Beta is
determined by the cyclicality of a firm's revenues. This cyclicality is magnified by the firm's
operating and financial leverage.
a. Revenues. The cyclicality of a firm's sales is an important factor in determining beta. In
general, stock prices will rise when the economy expands and will fall when the economy
contracts. As we said above, beta measures the responsiveness of a security's returns to
movements in the market. Therefore, firms whose revenues are more responsive to
movements in the economy will generally have higher betas than firms with less-cyclical
revenues.
b. Operating leverage. Operating leverage is the percentage change in earnings before interest
and taxes (EBIT) for a percentage change in sales. A firm with high operating leverage will
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Description
ECO3592011 UniversityofToronto PracticeProblems DepartmentofEconomics ECO 359 Practice Problems 2 Solution Guidelines 1. (a) Project A. (b) NPV of A is N $669, NPV of B is N $751. (c) For (a): interim cash flows can be reinvested at the respective IRR. For (b): they can be reinvested at the required rate of return r = 10%. 2. The discount rate for the project is equal to the expected return for the security, R , since the S project has the same risk as the firm as a whole. Apply the CAPM to express the firms required return, R S in terms of the firms beta, , the risk-free rate, R F and the expected market return, . - 0 : . ; L HHM - H{M 0 HH{ L IKMM Calculate the NPV of the cash inflows, using 13.55%. as the discounted rate: & L .-J2-=0-J4)O21)J2 - (#:I - N; ,KLHHH L .,IJHHHHH - (#:I - IKMM ; L .,IJHHHHH - ,IIO
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