Question

3. Intermountain Resources Inc. has three divisions with the following equity betas: Proportion Division Beta of Assets Lumber 0.7 50% Coal 1.2 30% Tourism 20% 1.3 The risk free rate is 7% and the market risk premium is 8%. The firm's debt costs 7.6% per year. Its tax rate is 25% a) What is Intermountain's cost of equity? b) If the firm uses 40% equity and 60% debt, what is the WACC? 4. Brennan's just paid a dividend of $1.50 per share. This is expected to grow at an 8% annual rate for the next three years; then it will grow at 2% in perpetuity. The coefficient of correlation of Brennan's with the market portfolio is 0.3 and its standard deviation is 24%. The expected return and standard deviation for the market are 12% and 9% respectively. a. What is the beta for Brennan's? b. If the risk-free rate of return is 5%, what is the required rate of return for Brennan's? c. What is the price of a single share of Brennan's?

Answer 1

1.
=risk free rate+beta*market risk premium
=7%+(0.7*50%+1.2*30%+1.3*20%)*8%
=14.76%

2.
=proportion of equity*cost of equity+proportion of debt*cost of debt*(1-tax rate)
=40%*14.76%+60%*7.6%*(1-25%)
=9.32%

3.
=correlation of stock with market*standard deviation of stock/standard deviation of market
=0.3*24%/9%
=0.80

4.
=risk free rate+beta*(market return-risk free rate)
=5%+0.80*(12%-5%)
=10.60%

5.
=1.50*(1.08/1.106)+1.50*(1.08/1.106)^2+1.50*(1.08/1.106)^3+1.50*(1.08/1.106)^3*1.02/(10.60%-2%)
=20.857