Corporate Finance

Exercise 1

Company X has the option to undertake an investment project characterized by an initial negative cash flow of £1m and an expected positive cash flow of £1.22m after one year. The project falls in the same class of risk as the firm as a whole and is 100% equity financed. The annual risk-free rate is 3%.

  1. Using the historical data on monthly rates of return on the company’s stock and the market for the last 12 years (se dataPS3.xls file) compute the beta for the project, its equity cost of capital, and its net present value, using the data’s entire time span. Assume that the CAPM holds for log returns. [You will need to transform the monthly returns into log returns using the LN function in excel. See the note at the end of the problem set on how to deal with log returns].
  2. Estimate the value of beta for the subsample obtained by taking only the last 8 years. What do you observe? Does your view of the profitability of the project as expressed by its NPV change? And if you take only the first 4 years?
  3. On the basis of this analysis, which of the following companies could be the one you have been analyzing? Give reasons for your choice.
    1. Twelve years ago, X was the monopolist operator of its mature national fixed-line telecommunication market, and imminent privatization was con- sidered a daunting challenge. However, after its aggressive expansion into both internet- based value added services, satellite communication and mo- bile telephony, even critical analysts consider X “one of the most intriguing technology companies of our time”.
    1. Twelve years ago, X was a leading company in its national potato processing sector, with a market share of 40% in the vodka market and 60% in frozen chips. Like other things about X, this has not changed much over the last ten years, but, as its CEO likes to say: “If it ain’t broken, why fix it? People will always eat potatoes!” – and the profits keep rolling in.
  1. Twelve years ago, X was one of a host of startups setting out conquer the nascent market for bio-degradable mousetraps. After the speculative frenzy of the so-called mousetrap bubble ended in tears in the second half of the past decade, many of the competitors went out of business, but X survived the shakeout as a more profitable and less speculative company.

Exercise 2

Alpha Corporation and Beta Corporation are identical in every way except their cap- ital structures. Alpha Corporation, an all-equity firm, has 5,000 shares outstanding, currently worth £20 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is £25,000. The cost of his debt is 12 percent per year. Each firm is expected to have earnings before interest of £35,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 12 percent per annum.

  1. What is the value of Alpha Corporation? What is the value of Beta Corporation?
  2. What is the market value of Beta’s equity?
  3. Determine Alpha’s and Beta’s (after interest) earnings.
  4. Assuming each firm meets its earnings estimates, what will be the pound return over the next year of an investor holding 20% of either firm’s equity?

By using homemade leverage, construct an investment strategy in which an investor purchases a fraction x (0, 1) of Alpha’s equity and replicates both the cost and pound return of purchasing a fraction x of Beta’s equity.

  • Is Alpha’s equity more or less risky than Beta’s equity? Explain.

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