Solutions Ch05

Chapter
5
Return Concepts
Solutions
1. A. The expected holding period was one year. The actual holding period was from
October 15, 2007 to November 5, 2007, which is three weeks.
B. Given fair pricing, the expected return equals the required return, 8.7 percent. The ex-
pected price appreciation return over the initial anticipated one-year holding period must
be equal to the required return minus the dividend yield, 2.11/72.08 = 0.0293 or 2.93
percent. Thus the expected price appreciation return was 8.7% − 2.93% = 5.77 percent.
C. The realized return was ($69.52 − $72.08)/$72.08 = −0.03552 or negative 3.55 percent
over three weeks. There was no dividend yield return over the actual holding period.
D. The required return over a three-week holding period was (1.00161)3 − 1 = 0.484 per-
cent. Using the answer to C, the realized alpha was −3.552 − 0.484 = −4.036 percent
or −4.04 percent.
2. For AOL Time Warner, the required return is
r = RF + β  E ( RM ) − RF  = 4.35% + 2.50 ( 8.04% ) = 4.35% + 20.10%

= 24.45%
For J.P. Morgan Chase, the required return is
r = RF + β  E ( RM ) − RF  = 4.35% + 1.50 ( 8.04% ) = 4.35% + 12.06%

= 16.41%
For Boeing, the required return is
r = RF + β  E ( RM ) − RF  = 4.35% + 0.80 ( 8.04% ) = 4.35% + 6.43%

= 10.78%
113
114 Solutions
3. A. The Fama–French model gives the required return as
r = T-bill rate
+ (Sensitivity to equity market factor × Equity risk premium)
+ ( Sensitivity to size factor × Size risk premium )
+ ( Sensitivity to value factor × Value risk premium )
For TerraNova Energy, the required return is
r = 4.7% + (1.20 × 4.5% ) + ( −0.50 × 2.7% ) + ( −0.15 × 4.3% )

= 4.7% + 5.4% − 1.35% − 0.645%
= 8.1%
B. TerraNova Energy appears to be a large-cap, growth-oriented, high-market-risk stock
as indicated by its negative size beta, negative value beta, and market beta above 1.0.
4. The required return is given by
r = 0.045 + (−0.2)(0.075) = 4.5% − 1.5% = 3.0%
This example indicates that Newmont Mining has a required return of 3 percent. When
beta is negative, an asset has a CAPM required rate of return that is below the risk-free
rate. Cases of equities with negative betas are relatively rare.
5. B is correct. The Fama–French model incorporates market, size, and value risk factors.
One possible interpretation of the value risk factor is that it relates to financial distress.
6. Larsen & Toubro Ltd’s WACC is 13.64 percent, calculated as follows:
Equity Debt WACC

Weight 0.80 0.20
After-Tax Cost 15.6% (1 − 0.30)8.28%
Weight × Cost 12.48% + 1.16% = 13.64%
7. A is correct. The backfilling of index returns using companies that have survived to the
index construction date is expected to introduce a positive survivorship bias into returns.
8. B is correct. The events of 2004 to 2006 depressed share returns but 1) are not a persistent
feature of the stock market environment, 2) were not offset by other positive events within
the historical record, and 3) have led to relatively low valuation levels, which are expected
to rebound.
9. A is correct. The required return reflects the magnitude of the historical equity risk pre-
mium, which is generally higher when based on a short-term interest rate (as a result of
the normal upward sloping yield curve), and the current value of the rate being used to
represent the risk-free rate. The short-term rate is currently higher than the long-term
rate, which will also increase the required return estimate. The short-term interest rate,
however, overstates the long-term expected inflation rate. Using the short-term interest
rate, estimates of the long-term required return on equity will be biased upward.
Chapter 5 Return Concepts 115
10. C is correct. According to this model, the equity risk premium is
Equity risk premium = {[(1 + EINFL ) (1 + EGREPS ) (1 + EGPE ) − 1.0] + EINC}

− Expected risk-free return
Here:
EINFL = 4 percent per year (long-term forecast of inflation)

EGREPS = 5 percent per year (growth in real earnings)
EGPE = 1 percent per year (growth in market P/E ratio)
EINC = 1 percent per year (dividend yield or the income portion)
Risk-free return = 7 percent per year (for 10-year maturities)
By substitution, we get:
{(1.04 ) (1.05) (1.01) − 1.0 + 0.01} − 0.07 = 0.113 − 0.07

= 0.043 or 4.3 percent.
11. C is correct. Based on a long-term government bond yield of 7 percent, a beta of 1, and
any of the risk premium estimates that can be calculated from the givens (e.g., a 2 percent
historical risk premium estimate or 4.3 percent supply-side equity risk premium esti-
mate), the required rate of return would be at least 9 percent. Based on using a short-term
rate of 9 percent, C is the correct choice.
12. B is correct. All else equal, the first issue’s greater liquidity would tend to make its required
return lower than the second issue’s. However, the required return on equity increases as
leverage increases. The first issue’s higher required return must result from its higher lever-
age, more than offsetting the effect of its greater liquidity, given that both issues have the
same market risk.
13. A is correct. This is the expected 3-year holding period return, calculated as:
3-year expected return = (V0 − P0)/P0 = ($29.00 − $20.75)/$20.75
= 39.76%.
14. C is correct. The realized holding period return (note that no dividends were paid during
the 3-year holding period) is 44.82%. Specifically, the realized 3-year holding period is
calculated as:
3-year realized return = (PH − P0)/(P0) = (30.05 − 20.75)/20.75
= 44.82%.
15. C is correct. A string of favorable inflation and productivity surprises may result in a series
of high returns that increase the historical mean estimate of the equity risk premium. To
mitigate that concern, the analyst may adjust the historical estimate downward based on
an independent forward-looking estimate.
16. A is correct. Given the data presented, the equity risk premium can be estimated as:
Equity risk premium = dividend yield on the index based on year-ahead aggregate
forecasted dividends and aggregate market value + consensus long-term earnings growth
rate − current long-term government bond yield. The equity risk premium = 1.2% +
4.0% − 3.0% = 2.2%.
116 Solutions
17. B is correct. The weighted average cost of capital is taking the sum product of each com-
ponent of capital multiplied by the component’s after-tax cost.
First, estimate the cost of equity using the CAPM:
Cost of equity = Risk-free rate + [Equity Risk Premium × Beta]
Cost of equity = 3.0% + [5.5% × 2.00] = 14%
Now, calculate Bezak’s WACC:
Equity Debt WACC

Weight 0.75 0.25
After Tax Cost 14% (1 − 0.30) × 4.9%
Weight × After Tax Cost 10.5% + 0.8575% = 11.36%
18. B is correct. The steps to estimating a beta for a non-traded company are:
Step 1 Select the comparable benchmark
Step 2 Estimate the benchmark’s beta
Step 3 Unlever the benchmark’s beta
Step 4 Lever the beta to reflect the subject company’s financial leverage
The beta of the benchmark peer company data is given as 1.09. Next, this beta needs to
be unlevered, calculated as:
 
 1 
βu =   βl
1 +  D  
  E  
 
 1 
βu =   (1.09 )
1 +  0 . 60 

  0.40  
βu = 0.436, or 0.44
Then, the unlevered beta needs to be levered up to reflect the financial leverage of Twin
Industries, calculated as:
  D ′ 
β′E ≈ 1 +    βu
  E ′ 
  0.49  
β′E ≈ 1 +    ( 0.436 )
  0.51  
βu = 0.8549, or 0.85
Chapter 5 Return Concepts 117
19. A is correct. Johansson intends to estimate a required return on equity using a modified
CAPM approach. Twin Industries is stated to be smaller than the chosen proxy bench-
mark being used and there is no size premium adjustment in the CAPM framework; the
framework adjusts the beta for leverage differences but this does not adjust for firm size
differences. The build-up method may be more appropriate as it includes the equity risk
premium and one or more additional premia, often based on factors such as size and per-
ceived company-specific risk.

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Chapter

r = RF + β  E ( RM ) − RF  = 4.35% + 2.50 ( 8.04% ) = 4.35% + 20.10%

For J.P. Morgan Chase, the required return is

r = RF + β  E ( RM ) − RF  = 4.35% + 1.50 ( 8.04% ) = 4.35% + 12.06%

For Boeing, the required return is

r = RF + β  E ( RM ) − RF  = 4.35% + 0.80 ( 8.04% ) = 4.35% + 6.43%

3. A. The Fama–French model gives the required return as

For TerraNova Energy, the required return is

r = 4.7% + (1.20 × 4.5% ) + ( −0.50 × 2.7% ) + ( −0.15 × 4.3% )

r = 0.045 + (−0.2)(0.075) = 4.5% − 1.5% = 3.0%

Equity Debt WACC

10. C is correct. According to this model, the equity risk premium is

Equity risk premium = {[(1 + EINFL ) (1 + EGREPS ) (1 + EGPE ) − 1.0] + EINC}

EINFL = 4 percent per year (long-term forecast of inflation)

{(1.04 ) (1.05) (1.01) − 1.0 + 0.01} − 0.07 = 0.113 − 0.07

Now, calculate Bezak’s WACC:

Equity Debt WACC

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