Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21. The market risk premium

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Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21. The market risk premium is 9.5 percent and the risk-free rate is 5 percent. We can determine the expected return on the common stock of Alpha Air Freight from Equation 13.1. We find that the expected return is:.05 + 1.21 x .095.16495, or 16.495%

Because this is the return that shareholders can expect in the financial markets on a stock with a β of 1.21, it is the return they expect on Alpha Air Freight’s stock.

Suppose Alpha is evaluating the following independent projects:Project A B C Project's Beta (3) 1.21 1.21 1.21 Project's Expected Cash Flows Next Year $140 120 110

Each project initially costs $100. All projects are assumed to have the same risk as the firm as a whole. Because the cost of equity capital is 16.495 percent, projects in an all-equity firm are discounted at this rate. Projects A and B have positive NPVs and Project C has a negative NPV, so only A and B will be accepted. This result is illustrated in Figure 13.2. Figure 13.2 Using the Security Market Line to Estimate the Risk-Adjusted Discount Rate for Risky ProjectsProject's internal rate of return (%) 40 20 16.5 105 1 1 Accept region .A B Reject region .C (NPV = $20.2)

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Corporate Finance

ISBN: 9781265533199

13th International Edition

Authors: Stephen Ross, Randolph Westerfield, Jeffrey Jaffe

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