Solved by verified expert :Finance Case: Beta and cost of Capital
Deadline: WEEK 4
IMPORTANT:
You have to hand in the assignment inweek 4 in the black mailbox on the fourth floor of the E-building
next to the secretarial office (E4.26) at the latest at. DO NOT HAND IT IN BY EMAIL! Solutions should be clearly typed. Only one
copy is required per group, and it should not be more than 3 pages. Recall that
one group should contain 3-4 students. Write the course code and the name and
student number of each student in the group on the front page and the exact day
and time of your tutorial class. Make sure that you provide intermediate steps
in your presentation of results so that one can follow how you ended up with
the final result.Only use the material provided on Blackboard (except
for question 5). Please remember: plagiarism is a
serious offence and its perpetrators will face sanctions.
The first goal of this assignment is to estimate
the cost of capital for 3 Dutch companies listed at the NYSE Euronext
Amsterdam. In this assignment you will analyze the cost of capital of ING, ASML
and Ahold at 31-12-2010.
The
necessary datafile (Dataset
Assignment 1.xls) can be downloaded from the blackboard site. This file contains
the stock market prices of the 3 companies and a stock market index, the AEX. Prices in this file already reflect
dividends! Hence you may ignore the effect of dividends in calculating returns.
Balance sheet information is included in the file: Balance Sheets.pdf. Use these data to answer the following
questions.
Question 1
a) Using
monthly data, estimate the equity betas over the period January 1, 2006 until
December 31, 2010 of ING, ASML and Ahold.
Hint: do not forget to calculate rates of return
first!
b) The AEX
index consists of only 25 companies, whereas the FTSE (UK) contains 100 and the
S&P (US) contains 500. Ceteris paribus, what would you expect to happen to
the beta of a company when the index in which it is contained consists of fewer
stocks? Why?
Question 2
The betas
that you’ve estimated in Question 1) are levered equity betas. To determine
project risk we are more interested in the unlevered equity betas or asset
betas. Based on the information you have in Question 1) plus the specific
capital structures (see Balance Sheets.pdf), estimate
for each of the 3 companies the asset beta. Assume initially that beta debt is
zero and ignore the impact of taxes.
(Use in
this question as a proxy for debt: Net Debt = Interest Bearing Debt – Cash and
Cash Equivalents)
Question 3
a)
Interpret the asset beta’s of ASML and Ahold on the basis of the fundamental
drivers of asset beta.
b) Now
examine the equity beta and the asset beta of ING and comment on their values.
Do you consider them high/low? Try to come up with an explanation.
Question 4
a) Until
now we have assumed that beta of debt is zero. For which of these three firms
is this a reasonable assumption, for which not?
b) Assume
that debt of each firm has a beta equal to 0.1. Recalculate the asset beta of
each firm (but assume there are still no taxes).
c) Now
assume that Ahold increases its debt to value ratio to 50%. What will happen to
Ahold’s equity beta? Motivate with a calculation. What will happen to its asset
beta?
In the next part we will look at the cost of capital. The objective
is to estimate the weighted average cost of capital (WACC):
This WACC plays an
important role in modern corporate finance, so understanding its underpinnings
is of the utmost importance. To determine the WACC one needs the required rate
of return on equity as well as on debt. Also the capital structure is needed as
an input. To determine the cost of equity and the cost of debt in a CAPM
framework, the risk free rate, the betas and the market risk premium are
needed.
Question 5
Determine
the risk free rate on December 31, 2010 by considering a maturity of 10 years.
Explain carefully where this number came from.
(Hint: Use the Internet, newspapers or DataStream)
Question 6
Assume the
market risk premium is 4% and use your answer found in the previous question as
a risk free rate to estimate the cost of equity for each of the three
companies.
Question 7
Now
calculate the WACC for each of the three companies (still ignoring the impact
of taxes). Assume that the beta of debt is equal to 0.1.
Question 8
The WACC in
the case where there are no taxes is independent of the relative proportions of
debt and equity. a) Explain why this is
the case.
b)
Give the most important
advantage and disadvantage of taking on debt from the perspective of the firm.
c)
Assume the corporate tax rate
is 40%. Calculate the after tax WACC for each of the three companies.
