(15 points)

3) Pluperfect Petroleum Inc.’s equity beta is 0.99.  Its debt-to-value ratio is 0.25, and the beta of its debt is 0.11.

a) What is their asset beta?

b) If they increase debt-to-value to .35, the debt beta will become 0.18.  What is their new equity beta at this debt level?                                                                                                                                                         (15 points)

4) At time 0, the Baschaproff Corp. must decide whether to invest $13,500,000 in clinical trials for their radical new product, Wyenottagra.  If the investment is made today, there is a 0.35 probability the firm will be ready to launch production at time 1, and a 0.65 probability that they will need additional trials costing $7,000,000.  If this happens, they can either abandon the project or continue the trials.  With a probability of 0.2, the second round of trials will be successful, and they will be ready to launch production at time 2.  If the second round of trials are not successful, they will abandon the Wyenottagra project at time 2.  The cost of running the trials is a sunk cost that cannot be recovered if the project is abandoned.

Whenever Baschaproff launches production, they will invest $650,000,000.  Cashflows will start from the following year, with an initial cashflow of $45,000,000 and a growth rate of 7% forever.  The required return is 13.5%. 

a) What is the NPV of the Wyenottagra project today?  Should Baschaproff Corp. launch clinical trials?

b) Now assume that if the first round of trials is not successful, they can spend $3,500,000 to find out for certain whether the second round will succeed.  What is the NPV of the project today once the availability of this information is taken into account?

(25 points)

5) Truly Awesome Overheads, a startup firm in the knowledge projection industry, is estimating the required return for its new project.  P, Q and R are three existing firms in the industry.  

                        Firm                        D                        ß_d                        E                   ß_e

                          P                        $12m                    0.2                      $28m            1.60

                          Q                        $24m                    0.3                      $24m            2.10

                          R                        $30m                    0.4                      $20m            2.25

a) Use the above information to estimate the project beta for TAO's project.

b) If S is another firm in the same industry, with a debt-to-value ratio of 0.4, and a debt beta of .25, estimate its equity beta.

(15 points)

6) Mark the following statements with a T or an F to indicate whether they are true or false (no explanations required or considered):                                                                                                                        (30 points)

a)   Firm-specific news and economy-wide news are both randomly positive or negative; it’s not clear why one type of news is diversifiable and one is not.

b)   A stock whose expected return is less than the riskfree rate will tend to go down when there is good news about the economy.

c)   If a stock has a beta greater than 1, the stock will tend to fluctuate more than the market when there is good news or bad news about the economy.

d)   If the economy is expected to do badly enough, the E(R) for the market portfolio can sometimes be less than the riskfree return.

e)   If a company increases its debt ratio (holding the investment decision constant), its debt beta will increase.

f)    If short-term interest rates are expected to increase, the yield on short-term treasuries today > (yield on long-term treasuries today + average historical difference between the two yields).

g)   Positive NPV projects plot to the left of the SML and negative NPV projects plot to the right.

h)   If the variables that are used to compute a project's cashflows are estimated carefully to begin with, we will not have to worry about errors in the estimated NPV.

i)    One problem that arises in the context of capital budgeting is that some long-term investments (e.g. R&D expenses) do not show up in the capital budget.

j)    If a project has positive NPV despite a high probability of bankruptcy, stockholders want the project to be accepted; in this situation, they regard bankruptcy as a calculated risk they are prepared to take.

k)   If stock prices increase sharply, they are then more likely to fall than to go up more.

l)    Stock prices follow a random walk with drift; the drift comes from the fact that expected return is positive.

m) If a market is weak-form efficient, it must automatically be semi-strong form efficient too.

n)   In an efficient market all securities are zero NPV investments.

o)    99% of the time anomalies do not work, but 1% of the time they work and allow you to beat the market.