Question

You have run a regression of monthly returns on a stock against monthly returns on the S&P 500 index, and come up with the following output:

Rstock = 0.25% + 1.25 RMarket R² = 0.60

The current one-year treasury bill rate is 4.8%, the current ten-year bond rate is 7.25% and the current thirty-year bond rate is 8%. The firm has 10 million shares outstanding, selling for $10 per share.

i. What is the expected return on this stock over the next year?

ii. Would your expected return estimate change if the purpose was to get a discount rate to analyze a thirty-year capital budgeting project?

iii. An analyst has estimated, correctly, that the stock did 4.2% better than expected, annually, during the period of the regression. Can you estimate the annualized riskfree rate that he used for his estimate?

iv. The firm has a debt/equity ratio of 50% and faces a tax rate of 40%. It is planning to issue $50 million in new debt and acquire a new business for that amount, with the same risk level as the firm's existing business. What will the beta be after the acquisition?