Homework SourseExplain and show steps for all questions 1Why are some risks
Explain and show steps for all questions
1.Why are some risks diversifiable and some non-diversifiable? Give an example of each.
3. Peter\'s Audio Shop has a cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter\'s Audio Shop?
4. On-line Text Co. has four new text publishing products that it must decide on publishing to expand its services. The firm\'s WACC has been 17%. The projects are of equal risk, ßs of 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects are expected to earn as follows:
Project W- 14% Project X- 18% Project Y- 17% Project Z- 15%
What projects should be selected and why?
Solution
Requirement 1:
The risk which is specific to the company and does not affect the overall market is called diversifiable risk and the risk which affects the overall market is called non diversifiable risk. Some risks affects only the company and some affects the entire market. Hence some risks are diversifiable and some are non diversifiable.
Requirement 2:
Expected Return on Stock A:
State of Economy
Probability
Return
Return * Probability
Boom
20%
18%
3.6%
Normal
70%
11%
7.7%
Recession
10%
-10%
-1%
10.3%
Expected Return on Stock B:
State of Economy
Probability
Return
Return * Probability
Boom
20%
9%
1.8%
Normal
70%
7%
4.9%
Recession
10%
4%
0.4%
7.1%
Expected Return on Stock A:
State of Economy
Probability
Return
Return * Probability
Boom
20%
6%
1.2%
Normal
70%
9%
6.3%
Recession
10%
13%
1.3%
8.8%
Expected Return on a portfolio:
Stock
Return
Weight
Return * Weight
A
10.3%
20%
2.06%
B
7.1%
50%
3.55%
C
8.8%
30%
2.64%
8.25%
Requirement 3:
Value of Common Stock = 104000 * 20 = $2080000
Value of Preferred Stock = 40000 * 34 = $1360000
Value of Bonds = 500000 * 102% = $510000
Total Value = $2080000 + $1360000 + $510000 = $3950000
Cost of debt, Kd = 7 (1-0.34) = 4.62%
Cost of preferred stock, Kp = 8%
Cost of Equity, Ke = 11%
Calculation of Weighted Average Cost of Capital:
Type of capital
Cost of Capital
Weight
Cost of Capital * Weight
Equity
11%
2080000/3950000 = 0.5266
5.7926%
Preferred Stock
8%
1360000/3950000 = 0.3443
2.7544%
Debt
4.62%
510000 / 3950000 = 0.1291
0.596442%
9.143442%
Requirement 4:
Since risk is same for all the projects, the project with higher return should be selected.
Here, Project X is with higher return of 18%.
Hence Project X should be selected.
| State of Economy | Probability | Return | Return * Probability |
| Boom | 20% | 18% | 3.6% |
| Normal | 70% | 11% | 7.7% |
| Recession | 10% | -10% | -1% |
| 10.3% |
