1. (1 point) Given debt and equity value figure, draw firm value. FIGURE A FIGURE B DEBT VALUE ($MILLION) 1 2 3 4 1.5 0.5 0 0.3 -0.3 0.6 -0.6 0.5 1.5 COMPANY CASHFLOW ($MILLION) RE 2 = EQUITY VALUE ($MILLION) -0.3 0.3 0.6 -0.6 1.5 0.5 0 1 1.5 0.5 COMPANY CASHFLOW (SMILLION) 2 RM = COMPANY VALUE (SMILLION) 2 1.5 2. (2 points) Find the CAPM beta of the following stock, where Rg is stock return, RM is market return, R is average of stock returns, RM is average of market returns, COV(R, RM) is covariance between R and RM, and VAR(RM) is variance of market returns. CAPM beta = COV(RE, RM)/VAR(RM)= Year RE RE-RE RM RM - RM 0.5 0 1 1.5 0.5 COMPANY CASHFLOW ($MILLION) FIGURE C (RE-RE) X (RM - RM) COV(RE, RM)= 2 (RM-RM) VAR(RM) = 3. (4 points) Currently, Hotel X has no debt (i.e., leverage=0). The CEO of Hotel X considers increasing leverage (=debt/(debt+equity)) 0.5. Currently, Hotel X's CAPM beta is 2.0. The cost of debt (RD) will be 10%, riskfree rate (RF) is 1%, and market return (RM) is 11%. Assume that the corporate tax rate (7) is ZERO. Your task, as the CFO of Hotel X, is to provide the cost of capital under this proposed capital structure (i.e., 50% leverage). 3-1. The method to compute the cost of capital is called ( _) cost of capital. 3-2. What is the CAPM beta under the proposed capital structure (i.e.,50% leverage)? D+E BE --PA E = BE = 3-3. What is the cost of equity under proposed capital structure (i.e., 50% leverage)? RE = RF + PE (Rm Rf) = RE = = 3-4. What is the cost of capital under the proposed capital structure (i.e., 50% leverage)? RW ACC D E (1 T)RD + RE RWACC = D+E D+E 4. (3points) Company X stockholders will decide on choosing one of the two following projects. Initial Cost Cashflow in Boom (50% probability) Cashflow in Bust (50% probability) $130 Project A Project B $190 4-1 If the Project initial cost, C, is $20 which is financed by debt, which project will be chosen by stockholders? $90 $10 4-2 If the Project initial cost, C, is $100 which is financed by debt, which project will be chosen by stockholders?