FINA 3070 AB Corporate Finance: Theory and Practice

Homework 2 Answer Sheet

Tse Fuk Chun

Full Name: ______________________________

1155176354
Student ID: ______________________________

Chapter 9’s problem 4. a. What is the required return on Okefenokee

stock? 13 %

4%
Required etuon = + 1 5× 6
-
%
= 13 %

b. Estimate the company cost of capital.

9 4%.

awst of capital : 4% 先+ 13% 兵

Reqaind
x .
x
.

=
9 %..

c. What is the discount rate for an expansion of the company’s present

business? Briefly explain your answer. 9 4%.

5 therisle of thn
s

is similar tothe risk

projects
I

erpansion '

of all other existi and assets the discoumt rule

y projel
' ,
,

Nould be the risk of the which cost of

projeets is
capieal ,

Theetone the disaint ate 2

9 . 4%
,

d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of
optical manufacturers that have no debt is 1.2. Estimate the required return on Okefenokee’s new venture
for the following three situations, and briefly explain your answers (hint: the new venture’s βA = 1.2, and
its βE will depend on its financial leverage):
i. Calculate the discount rate for the new venture if Okefenokee only uses an increase in retained
earnings to finance the new venture.

11 .
2%

1
β =β
= .

E A

EC ^ E
) = 4
%+ 1 .2 × 6%

1
又
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

E ( rE ) 11 . %
2

Sine the new wentne is only

finmmed by eyuity ,
ECrE 了 =
ECNA ) =
11 . 2 %

ii. Calculate the opportunity cost of equity capital if Okefenokee finances 40% of the new venture using
new debt (same cost as existing debt) and the remaining 60% using an increase in retained earnings.
Calculate the discount rate for the new venture.
rE: 6% WACC: 11 2
% .

rE = 11 2
.
% + 毙 ( 12% -
4% )

=
16 %

r =
WACC = 0 .
4 ×
4% + 0. 6 × 16 %

=
11 2% .

discomtrate 11 2 %
I Requied
= .
,

iii. Repeat (ii), assuming Okefenokee now needs to pay corporate tax rate of 26%. Hint: the cost of equity
will be the same as (ii), but the discount rate for the new project will differ from (ii).

rE: 16 % WACC (After-tax): 10 784 %

.

r =
WACC lafer -
ex ) = 0 .
4 × 4% × ( 1 26
-

Y)
- + 0 .
6 × 16 %
=
10 784 %.

i .

Requred diswountrate = 10 .
784 % ,

2
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

Chapter 9’s problem 9 What proportion of U.S. Steel’s returns was explained by market movements?

0 .

23

=R
Required proportion 0 23
= -

What proportion of risk was diversifiable?

0 .
77

Required proportion 1 0 23
-
,

0 . 77

How does the diversifiable risk show up in the plot?

The shous the securities ' k

SCL
^
in thegraph
systemetic ris and

rate of return and so sCL shous the dinersifiable riik

up .

What is the range of possible errors in the estimated beta?

ange = 95 f beG
Required %( I

= ( 2 98 .
-
0 .
72 x 2 2 . 98 + 0 .
72 × 2)
,

=
d 54.

,
4 42 )
.

3
二
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

Chapter 9’s problem 16

(a) Explain what will happen to the operating leverage and business risk if you agree to the fixed-price
contract (You need not calculate the operating leverage and the business risk). Hint: see the table in
slide37 of Notes3

Sine the fixed costincreases the ,

levesage will incoease and the
^

operaeing
breaakever of assets also which 0 lend
higher
incneases
price , to the business

risk ,

(b) Calculate the present value of the encabulator machine with the fixed-price contract.

(1 員
PV
. %
20000 *
- 0
=
y
-
10 , 0000 o o x

%…
—

xio

$ 101 ,
686 817
,
. 6

Calculate the present value of the encabulator machine without the fixed-price contract.

pu =
20 ,
,

…
.
000

,
器

=$ 111
, 111 , 111 s

4
二
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

Chapter 10’s problem 27 Read pages 288-290 of the textbook to understand Figure 10.3. The R&D team
has put forward a proposal to invest an extra $20 million in expanded phase II trials. If successful, the
upside PV increases to $1 billion. Is the extra $20 million investment worthwhile? (The phase III success
probability is unchanged)
anvest 130 ! 80 % s
Upscess
.

29 S 56 ide PU ,
=
700

560
8
363
t 30 295
IOO
=
×0
NPU
=
.
=

PO =
z -
18 ÷ 19 25 %
20
Fnil Fail , PU = 0

!
5 8
52 × O
Inrest 130 ?
× 0
300
. .

44 %

%
×
100 + 295 × 0 25 240 80
likly
.

essMost
= 100
2
1 44% SHcceSS
100
5o % .
52 240 ←
su
,

PU = 300
Invest
56 %
NPV =

130
=32 20%
18 ? -
0s Fail , PV
Eal“
=
Fail
s :
25%
Invest 130 ? 100 × 0 8
= 80
80 %
.

Dounsiode PO ,
socass
0 8 0 =

=
100

80 130 ÷ 69 < o 20%

-

PV = 0

σ
-

963 Fail

The decision thee abme isphase success 88 %

probabiliy ,

withoul the

exera investment

wpv =$ 9
oxoisnmest
130 ?
8
器 cass
478 800
Upside
PV =
1000
,

NPV =
80
≈ 930 20%.
Fai ]
-

1
0963 Fail , PU =
25
.

/ =
64 47
38 25
478× 0
-

N们 0962
.

1
05
.

146 + S2×
÷ 1S 300 8
44% 44 % Invest 130 ? %0 80% Most likely
. 50
.

⑬
0
GeceaGs
sucuss 146
%

64 240 PU 300

30
=

\
Invest 38 ?
36 wiv :
20
oEail PUco

misop,
Fail .

÷2
25 % 8
80 %
.

100 × 0 .

Invest 130 } suceass

Domnsile ,

PV = 0
80
0 PV =
co 0

80 130
= -

69G 0 20%
NPV :
Fail BU =

F
O
-

0963 F们
,

The dewsio tree abore

.
is Phuse
I sucass
probabiliem
80 % , withtheextrsinmestment ,

NPU =$ ( Sm <$ 9 m

theextrn m investmentis not

: .
20 $ worthwhile

5
一
一几二
。
。
飛
艸
二
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

Chapter 10’s problem 27 Read pages 288-290 of the textbook to understand Figure 10.3. The R&D team
has put forward a proposal to invest an extra $20 million in expanded phase II trials. If successful, the
upside PV increases to $1 billion. If the probability of success in the phase III trials increases to 85% due
to the extra investment, is the extra $20 million investment worthwhile?
Innest 130 ?
cces
85

“ 8830 Opsile
1000 × 0 85 PU =
1000
熟
-

8
NPU =
130

YFai
0963
-

13
25 % 1 .

÷ 516 1 PVe
NPV 263 38

fyS
-

25
% 516 ! 300 × 0
0
161 × 44
InrstBo
×

(
.

= 2(
Mostly lilely
to 4
y
xo s
30
.

㉑ U 44 %
女
161 ④ 255
Suceess
PU = 300

Inest 58 ? SuCces 多
NPU = 130 15 % O
FailPU
-
=

s
∴
( 1 -
096 Fail
P0
0

stp
:

= 64
.

25 %
Imut 130 ? 100 × 0085
85 % Douwnside
Success
0
⑧
s PU =
100

85 6S <
above 130 =
-

NPV =≈ ( 5%
-

a 03 Fail , BU = O

/ Eail
Thethe
diagom Phase sucess
I

is
prrbnbilieq 851 with
<

.
,

the

extra investment ,

NPU $21
=
m
> 19 m

: The eatra investment is warthwhile

l
$a0 m

6
、
、
。
 FINA 3070 AB Corporate Finance: Theory and Practice
Homework 2 Answer Sheet

I declare that the assignment here submitted is my original work except for source material
explicitly acknowledged. The assignment here submitted is not produced with the
collaboration of or supported by the use of any generative AI tools. The same or closely
related material has not been previously submitted for same or different courses. I have not
distributed/ shared/ copied any teaching materials without the consent of the course
teacher(s). I also acknowledge that I am aware of University policy and regulations on
honesty in academic work, and of the disciplinary guidelines and procedures applicable to
breaches of such policy and regulations, as contained in the website
http://www.cuhk.edu.hk/policy/academichonesty/.

sh
___________________ /~
___________________
Signature Date
Tse Fulk Chun
___________________ 1155176394
___________________
Name Student ID
Fina 3070
__________________ Corporate Finane :Theory Practie
_______________________________________
&

Course code Course title

Note: Please check the submission pdf is in correct order and in 7 pages. Submission in other file formats
will not be accepted.

- The end -

7
水