1.

(10 Points)

Nero Violins has the following capital structure:


Security Beta Total Market Value ($ millions)

Debt 0 100

Preferred Stock 0.20 40

Common Stock 1.20 200



(A) (2 points)
What is Neros asset beta?

The asset beta is a weighted average of the betas of the different securities:

73 . 0 2 . 1 *
200 40 100
200
2 . 0 *
200 40 100
40
0 *
200 40 100
100
=
+ +
+
+ +
+
+ +
=
asset
|


(C) (2 points)
Assume that the CAPM is correct (with a risk free rate of 5% and a market risk premium of 6%)
and assume that there are no corporate taxes. What discount rate should Nero use for an across
the board expansion?

Nero should use the cost of capital that corresponds to its asset beta of 0.73:

% 38 . 9 % 6 * 73 . 0 % 5 ) _ ( * = + = + = premium risk r r
asset f asset
|


14. You are given the following information for Golden Fleece Financial.
Long-term debt outstanding: $300,000
Current yield to maturity (rdebt): 8%
Number of shares of common stock: 10,000
Price per share: $50
Book value per share: $25
Expected rate of return on stock (requity): 15%
Calculate Golden Fleeces company cost of capital. Ignore taxes.

The total market value of outstanding debt is $300,000. The cost of debt capital
is 8 percent. For the common stock, the outstanding market value is:
$50 10,000 = $500,000. The cost of equity capital is 15 percent. Thus,
Loreleis weighted-average cost of capital is:
) (0.15
500,000 300,000
500,000
0.08
500,000 300,000
300,000
r
assets

|
|
.
|

\
|
+
+
|
|
.
|

\
|
+
=

r
assets
= 0.124 = 12.4%


11. An oil company is drilling a series of new wells on the perimeter of a producing oil field.
About 20 percent of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the
amount of oil produced: 40 percent of new wells that strike oil produce only 1,000 barrels a day; 60 percent produce
5,000 barrels per day.

a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $15 per barrel.

Expected daily production = (0.2 0) + 0.8 [(0.4 x 1,000) + (0.6 x 5,000)]
= 2,720 barrels
Expected annual cash revenues = 2,720 x 365 x $15 = $14,892,000


b. A geologist proposes to discount the cash flows of the new wells at 30 percent to offset the risk of dry holes. The
oil companys normal cost of capital is 10 percent. Does this proposal make sense? Briefly explain why or why not.

The possibility of a dry hole is a diversifiable risk and should not affect the discount rate. This possibility
should affect forecasted cash flows, however. See Part (a).