Investment Theory:

(Assume no corporate taxes unless noted otherwise)

Consider firms A and B:

The risk-free rate is 4%, and the expected return on the market portfolio is 15%. Assuming the CAPM holds and that there are no taxes or costs of financial distress, answer the following:

a. Calculate the asset beta for firm A and for firm B. (Recall: the beta of a portfolio is a weighted average of the underlying betas)

b. Given your answer in (a), calculate the expected return on assets for firms A and B.

c. Firm A is thinking of investing in the same line of business that B is engaged in. What discount rate should it use for that investment?

d. A has invested in Bs line of business. These projects now constitute 10% of the overall value of company A. What will As new asset beta be? (Recall: the beta of a portfolio is a weighted average of the underlying betas)

e. Given that its debt/equity ratio and the beta of its debt remain unchanged, what will the new equity beta of A be?

Company A Company B Debt Beta (0.2 Equity Beta 1.4 Debt/Equity 0.4 0.6