In Chapter 4, we expressed the value of a share of stock as:

P0 5 EPS1 r

1 PVGO

where EPS 1 is earnings per share from existing assets, r is the expected rate of return required by investors, and PVGO is the present value of growth opportunities. PVGO really consists of a portfolio of expansion options. 20

a. What is the effect of an increase in PVGO on the standard deviation or beta of the stock’s rate of return?

b. Suppose the CAPM is used to calculate the cost of capital for a growth (high-PVGO)
firm. Assume all-equity financing. Will this cost of capital be the correct hurdle rate for investments to expand the firm’s plant and equipment, or to introduce new products?AppendixLO1

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Cumulative construction cost Total cost of design B Total cost of design A Time, months 0 12 24 36 Start A Start B Both plants would be ready at this time