BS97318

Corporate Finance
Tutorial 3

MSc Finance and Accounting

Adrian Lam
[email protected]

Imperial College London

October 30, 2019

Logistics Conceptual Practical: Comments Wrap Up

Plan for Today

Plan for today

Conceptual Problems: Solutions
Practical Problems: Some Comments
Come to my office hour for in-depth feedback

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Conceptual Problems

Conceptual Problems

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Question 1: Question

Question 1
The following is the beta calculation for Pepsi, using monthly return data
from the last 5 years:

E [rPepsi ] − rf = 0.23% + 1.2 × ERP (1)

You are given the following additional information: The current market
value of equity at Pepsi is $40 billion and the firm has $10 billion in debt
outstanding. During the last 5 years, Pepsi had an average market value
debt to equity ratio of 10%. The firms marginal tax rate is 40%. Using
the raw beta estimate from the regression above, and the information
provided, estimate Pepsi’s current beta.

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Question 1: Solution

What is the unlevered beta for Pepsi?

L
βPepsi
U
βPepsi =
1 + (1 − t)(D/E )Pepsi
1.2
= = 1.13
1 + (1 − 0.4)(0.1)
10
What is the levered beta with a debt-to-equity ratio of 40 ?

L 10
βPepsi = 1.13 × (1 + (1 − 0.4) ) = 1.30
40

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Question 2: Question

Question 2
Consider the merger between Disney and Cap Cities as discussed in class.
Find out the levered beta for the post-merge firm under the assumption
that Disney funded the entire acquisition with debt (all $18.5 billion).

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Question 2: Solution

Financial information from lecture slides:

Disney Cap Cities

Market Value of Equity $31,100M $18,500M
Equity Beta (Levered) 1.15 0.95
Equity Beta (Unlevered) 1.08 0.93
Debt $3,186M $615M
Firm Value $34,286M $19,115M
D/E Ratio 0.1 0.03
Equity Beta (Post-merger, Unlevered) 1.026

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Question 2: Solution
What is the essense of this question?
How to get the right debt-to-equity ratio post-merger
What is acquired in an acquisition?
“Assume” taget firm liabilities (i.e. paying over time by fulfilling
promises)
“Acquire” target firm equity (i.e. what you really buy)
Best way is to think in terms of a balance sheet
How is the deal recorded in Disney’s balance sheet?
If Disney raises equity to finance the deal
Assets Liabilities Equity
Disney $34,286M $3,186M $31,100M
Deal: CapCities + $19,115M + $615M + $18,500M

If Disney raises debt to finance the deal

Assets Liabilities Equity
Disney $34,286M $3,186M $31,100M
Deal: CapCities + $19,115M + $615M + $0M
+ $18,500M

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Question 2: Solution
What is the total amount of debt post-merger?
With new total debt (DT ), Disney’s debt (DDisney ), Cap Cities’ debt
(DCC ) and merger-incurred debt (DMerger ),
DT = DDisney + DCC + DMerger = $3186M + 615M + 18500M
=$22301M
What is Disney’s new debt-equity ratio?
Deal is all debt financed so post-merger equity comprises only Disney’s
equity
Assuming Disney’s equity remains unchanged
DT 22301
=
EDisney 31100
What is the new equity beta for post-merger Disney?
L 22301
βDisney, Post = 1.026 × (1 + 0.64 × )
31100
= 1.496859
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Question 3: Question

Question 3
General Motors is considering undertaking an investment project in a new
electric car called Priw (stands for “Prius-wannabe”). The cost of the
initial investment is $8 million in year zero. The project then yields the
following expected cash flows (in millions):
Year 1: $0
Year 2: $2.2
Year 3: $7.9
Year 4: $7

3(a). Suppose that the risk-free rate is equal to 5%, and that the expected
return on the market portfolio is equal to 12%. If this projects beta is equal
to 1.4, what is the firms required rate of return (a.k.a. cost of equity)?

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Question 3(a): Solution

What is the required rate of return using a project-specific

CAPM?

rPriw = rf + βPriw × ERP

= 5% + 1.4 × (12% − 5%)
= 14.8%

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Question 3(b): Question and Solution

Question 3(b)
3(b). Should the firm undertake the project? Answer yes or no and explain
why.

What is the net present value of the project?

T
X CFPriw ,t
NPV =
(1 + rPriw )t
t=0
2.2 7.9 7
= −8+ 2
+ 3
+
1.148 1.148 1.1484
= 2.92

Should accept the project since net present value is positive, i.e.
pursuing project adds value to the firm
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Question 3(c): Question and Solution

Question 3(c)
3(c). Suppose that a close competitor, Ford Motor Co, is evaluating a
similar car project. Fords project has identical cost and cash flows between
years 2 and 4, but has an additional positive cash flow in year one. If Fords
project has an internal rate of return of 30%, what is its cash flow in year
one equal to?

What is the internal rate of return of the project?

T
X CFFord,t
0=
(1 + IRRFord )t
t=0
CFFord,1 2.2 7.9 7
= −8+ + 2
+ 3
+
1.3 1.3 1.3 1.34
CFFord,1 = 0.847

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Question 4: Question

Question 4
Suppose that you know that the unlevered firm beta for BMW is equal to
1, and that BMW has a cash balance equal 20% of the firm value. What
is then the beta of its operating assets (aka as cash-adjusted beta)?
Hint: Remember that the firm value is FV = E + D, and that the value of
operating assets, or enterprise value, is given by EV = FV - Cash.

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Question 4: Solution

What implications does holding cash have on firm risk?

With enterprise value (EV ), book value of operating assets (OA) and
book value of non-operating assets (C ),

EV = OA
= FV − C

Since a firm’s beta is the value-weighted sum of its components, we

can re-express the value equation in betas:

FV = OA + C
FV EV C
× βFirm = × βOA + × βC
FV FV FV

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Question 4: Solution

Since cash does not respond to market risk, βC = 0, we can simply

EV C
βFirm = × βOA + × βC
FV |FV {z }
=0 since βC equals 0
EV
= × βOA
FV
Since we know that EV = FV − C , we can plug this in:

FV − C
βFirm = × βOA
 FV 
C
= 1− × βOA
FV

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Question 4: Solution

From the question, we know that βFirm = 1 and C /FV = 20%

 
C
βFirm = 1 − × βOA
FV
1 = (1 − 0.2) × βOA
βOA = 1.25

With cash holding, firm beta is lower than pure-play beta

The more cash an unlevered firm holds, the greater the difference
between pure-play and firm betas
Pure-play beta (i.e. beta of operating assets) is higher than unlevered
firm beta since cash is not responsive to market risk

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Question 5(a): Question

Question 5(a)
Novell, which had a market value of equity of $2 billion and a beta of
1.50, announced that it was acquiring WordPerfect, which had a market
value of equity of $1 billion, and a beta of 1.30. Neither firm had any debt
in its financial structure at the time of the acquisition, and the corporate
tax rate was 40%.

5(a). Estimate the beta for Novell after the acquisition, assuming that the
entire acquisition was financed with equity.

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Question 5(a): Solution

What is the unlevered beta post acquisition?

Post-acquisition beta is just the value-weighted average of equity betas.
VNovell, Pre
βNovell, Post = × βNovell,Pre
VNovell, Post
VWorldPerfect, Pre
+ × βWorldPerfect,Pre
VNovell, Post
2 1
= × 1.5 + × 1.3
1+2 1+2
= 1.43

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Question 5(b): Question

Question 5(b)
5(b). Assume that Novell had to borrow the $1 billion to acquire
WordPerfect. Estimate the beta after the acquisition.

What is the new debt-to-equity ratio?

Assets Liabilities Equity
Novell $2M $0M $2M
Deal: WordPerfect (debt-financed) + $1M + $1M + $0M

What is the levered beta?

 
L U D
βNovell, Post = βNovell, × 1 + (1 − t) ×
Post
E
 
1
= 1.43 × 1 + (1 − 0.4) ×
2
= 1.86
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Question 6(a): Question

Question 6(a)
Xiaomi, a cellphone company, is considering expanding its operations into
the media business. The beta for the company at the end of 2010 was
0.90, and the debt/equity ratio was 1. The media business is expected to
be 30% of the overall firm value in 2016, and the average beta of
comparable firms is 1.20; the average debt/equity ratio for these firms is
50%. The marginal corporate tax rate is 36%.

6(a). Estimate the beta for the company in 2016, assuming that it
maintains its current debt/equity ratio.

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Question 6(a): Solution

Unlevering Xiaomi’s firm beta (βPhone ) using the following formula,
U L 1
βPhone = βPhone × D
1 + (1 − t) × E
1
= 0.9 ×
1 + 0.64 × 1
= 0.55

Assuming Xiaomi’s media business is similar to the industry, we can

plug in the industry averages to obtain an estimated beta
U 1
βMedia = 1.20 ×
1 + 0.64 × 0.5
= 0.55

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Question 6(a): Solution

U
Unlevered beta for Xiaomi after its expansion (βXiaomi )is simply the
weighted average sum of unlevered betas of both the phone and
media businesses
U U VU
βXiaomi = βPhone × U Phone U
VMedia + VPhone
U
VMedia
U
+ βMedia × U U
VMedia + VPhone
= 0.55 × 0.7 + 0.91 × 0.3
= 0.66
U
Levering up βXiaomi by its debt-equity ratio,
L 1
βXiaomi = 0.66 ×
(1 + (1 − 0.36) × 1.0)
= 1.08
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Question 6(b): Question and Solution

Question 6(b)
6(b). Estimate the beta the company in 2016, assuming that it decides to
finance its media operations with a debt/equity ratio of 50%.

Need to calculate the new debt-equity ratio to lever up βXiaomi, U

Since 70% of Xiaomi’s business is in cellphone and 30% of Xiaomi’s
business is in media, we can write Xiaomi’s value ≡ VXiaomi as
VXiaomi = 0.7 × VPhone + 0.3 × VMedia
Using the debt-to-equity ratio for each business, we can obtain the
respective debt-to-assets ratios:
DPhone
= 1 =⇒ DPhone = EPhone =⇒
EPhone
DPhone DPhone 1
= =
VPhone DPhone + DPhone 2
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Question 6(b): Solution

Using the debt-to-equity ratio for each business, we can obtain the
respective debt-to-assets ratios:
DMedia
= 0.5 =⇒ DMedia = 0.5EMedia =⇒
EMedia
DMedia DMedia 1
= =
VMedia DMedia + 2 × DMedia 3
Hence, we can calculate the new debt-to-asset ratio for Xiaomi using
the weighted average debt-to-asset ratios of both businesses:
DXiaomi DPhone DMedia
= 0.7 × + 0.3 ×
VXiaomi VPhone VMedia
1 1
= 0.7 × + 0.3 × = 0.45
2 3

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Question 6(b): Solution

New debt-to-equity ratio is

DXiaomi DXiaomi VXiaomi 0.45
= × =
EXiaomi VXiaomi − DXiaomi VXiaomi 0.55
9
=
11
Levering βXiaomi, U with the new debt-to-equity ratio,
 
L U DXiaomi
βXiaomi =βXiaomi × 1 + (1 − t) ×
EXiaomi
 
9
= 0.66 × 1 + (1 − 0.36) ×
11
= 1.01

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Question 7(a): Question

Question 7(a)
The accompanying table summarizes the percentage changes in operating
income, percentage changes in revenue, and betas for four pharmaceutical
firms.

Firm % Change in Revenue % Change in Operating Income Beta

PharmaCorp 27% 25% 1.00
SynerCorp 25% 32% 1.15
BioMed 23% 36% 1.30
Safemed 21% 40% 1.40

7(a). Calculate the degree of operating leverage for each of these firms.

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Question 7(a): Solution

Two measures of operating leverage to gauge proportion of total

costs that are fixed
Fixed Costs
Fixed Costs Measure =
Variable Costs
%∆EBIT
EBIT Variability Measure =
%∆Revenues
Information on fixed and variable costs usually unavailable so the
EBIT variability measure is more practical
Firm %∆EBIT/%∆ Revenue Beta
PharmaCorp 25%/27% = 0.93 1.00
SynerCorp 32%/25% = 1.28 1.15
BioMed 36%/23% = 1.57 1.30
Safemed 40%/21% = 1.9 1.40

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Question 7(b): Question

Question 7(b)
7(b). Use the operating leverage to explain why these firms have different
betas.

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Question 7(b): Solution

What does this tell us?

Higher earnings variability means small error in forecasted revenues
can be magnified into large errors in forecasted operating income, i.e.
cash flows are riskier

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Question 8(a): Question

Question 8(a)
You have collected returns on AnaDone Corporation (AD Corp), a large
diversified manufacturing firm, and the NYSE index for five years. Assume
the risk-free rate is 2%.

Year Risk-free Rate Return on AnaDone Return on NYSE

1981 2% 10% 5%
1982 2% 5% 15%
1983 2% -5% 8%
1984 2% 20% 12%
1985 2% 5% -5%

8(a). Estimate the intercept (α) and slope (β) of the regression.

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Question 8(a): Solution

Suppose we run a regression using CAPM

rAD Corp = rf + β × (rNYSE − rf ) +εAD Corp

| {z }
ERP

What is the estimated beta for AD Corp (βADˆCorp )?

ˆ (rAD Corp , ERP)

Cov
β̂AD Corp =
ˆ (ERP)
Var
= 0.60

What is the estimated intercept α̂?

â = ȳ − β̂AD Corp ERP

= 0.0592

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Question 8(a): Solution

There are three ways to specify your regression model
If you run the excess return of a stock on the equity risk premium, then
the regression, and with Jensen’s alpha (αi ),

(ri − rf ) = α̂i + β̂ × (rM − rf )

If you run the return of a stock on the equity risk premium, then the
regression, and with Jensen’s alpha (αi ),

ri = (α̂i + rf ) + β̂ × (rM − rf )
| {z }
Intercept

If you run the return of a stock on return of the market, then the
regression, and with Jensen’s alpha (αi ),

ri = (α̂i + (1 − β) × rf ) + β̂ × (rM )
| {z }
Intercept

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Question 8(a): Solution

Summary statistics
Average return on NYSE: 3.8%
Average ERP: 1.8%
Regression results
(1) (2) (3)
CAPM Raw Excess
ERP 0.601 – 0.601
(1.57) – (1.57)

rNYSE – 0.601 –
– (1.57) –

Intercept 0.0592 0.0472 0.0392

(1.67) (1.25) (1.10)
N 5 5 5

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Question 8(b): Question

Question 8(b)
8(b). If you bought stock in AD Corp. today, how much would you expect
to make as a return over the next year? (Assume that the the six-month
Treasury bill rate is 2%).

What is the CAPM-implied return?

Using the CAPM with rf = 2% and using the historical average of
equity risk premium as ERP,

E [rAD Corp ] =rf + β̂AD Corp ERP

= 0.02 + 0.6 × 0.018
= 0.0308

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Question 8(c): Question

Question 8(c)
8(c). Looking back over the last five years, how would you evaluate ADs
performance relative to the market? (The average risk-free rate during the
period was 5%).

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Question 8(c): Solution

Re-running the regressions with a 5% risk-free rate

(1) (2) (3)
CAPM Raw Excess
ERP 0.601 0.601
(1.57) (1.57)

rNYSE 0.601
(1.57)

Intercept 0.0772 0.0472 0.0272

(2.20) (1.25) (0.78)
N 5 5 5

What is Jensen’s alpha?

Different models require different ways to compute Jensen’s alpha, see
Question 8(a)
Stock of AD Corp outperformed the market since Jensen’s alpha is
positive (0.272)

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Question 8(d): Question

Question 8(d)
8(d). Assume now that you are undiversified investor and that you have all
of your money invested in AD Corporation. What would be a good
measure of the risk that you are taking on? How much of this risk would
you be able to eliminate if you diversify?

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Question 8(d): Solution

What risk does an undiversified investor assume?

An undiversified investor bears all risks of the investment, i.e. both
systematic and idiosyncratic risks. The (sample) standard deviation
and the total beta are good measures in this case.
How much of this risk would you be able to eliminiate if you
diversify?
You can eliminate all idiosyncratic risks through diversification.
R-squared tells you how much of the variance in the dependent variable
is explained by the independent variable. Hence, the amount of risk
that could be eliminated through diversification is

1 − r-squared = 1 − 0.45
= 0.55

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Question 8(e): Question

Question 8(e)
8(e). AD is planning to sell off one of its divisions. The division under
consideration has assets that comprise half of the book value of AD
Corporation, and 20% of the market value. Its beta is twice the average
beta for AD Corp. (before divestment). What will the beta of AD
Corporation be after divesting this division?

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Question 8(e): Solution

What is the beta of the divested division (βDiv )?

βDiv = 2 × βAD Corp = 2 × 0.6

= 1.2

What is the beta of the remaining assets βRem ?

If the cash is paid out and the capital structure is unaffected

βAD Corp = 0.2 × βDiv + 0.8 × βRem

0.6 = 0.2 × 1.2 + 0.8 × βRem
βRem = 0.45

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Question 9(a): Question

Question 9(a)
You are trying to estimate the beta of a private firm that manufactures
home appliances. You have managed to obtain betas for publicly traded
firms that also manufacture home appliances.

Company Beta Debt Equity

Black & Decker 1.40 2500 3000
Fedders 1.20 5 200
Maytag 1.20 540 2250
National Presto 0.70 8 300
Whirlpool 1.50 2900 4000

The private firm has a debt-to-equity ratio of 25% and faces a tax rate of
40%. The publicly traded firms all have marginal tax rates of 40% as well.

9(a). Estimate the beta for the private firm.

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Question 9(a): Solution

Calculate firm value, debt-to-equity and unlevered beta for each of

the public firms
Company Firm Value Debt-to-Equity Ratio Unlevered Beta
Black & Decker 5,500 0.8333 0.933
Fedders 205 0.025 1.182
Maytag 2,790 0.24 1.049
National Presto 308 0.0267 0.689
Whirlpool 6,900 0.725 1.045

Calculate the value-weighted average of unlevered beta to get an

estimate for the private firm
β¯U = 1.001
Value-weighting the betas implies we put a heavier emphasis on more
valuable firms
Using a simple average ignores size effects: how important is this?

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Question 9(a): Solution

Levering up β¯U with a 25% debt-to-equity ratio and 40% tax rate to
obtain beta for the private firm (βPrivate )
 
¯ D
βPrivate = βU × 1 + (1 − t) ×
E
 
1
= 1.001 × 1 + (1 − 0.4) ×
4
= 1.152

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Question 9(b): Question and Solution

Question 9(b)
9(b). What concerns, if any, would you have about using betas of
comparable firms?

Beta measures responsiveness to market (systemic) risk, but private

firms have a great deal of idosyncratic, firm-specific risk
Comparability and representativeness (e.g. business mix, geographical
location, clientelle, etc)
Financing constraints and liquidity needs

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Question 10(a): Question

Question 10(a)
As the result of stockholder pressure, RJR Nabisco is considering spinning
off its food division. You have been asked to estimate the beta for the
division, and decide to do so by obtaining the beta of comparable publicly
traded firms. The average beta of comparable publicly traded firms is
0.95, and the average debt/equity ratio of these firms is 35%. The division
is expected to have a debt/equity ratio of 25%. The marginal corporate
tax rate is 36%.

10(a). What is the beta for the division?

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Question 10(a): Solution

What is the average unlevered beta of the comparable firms?

U 1
βComp. = 0.95 ×
1 + (1 − 0.36) × 0.35
= 0.7761

What is the levered beta for the food division?

L
βFood = 0.7761 × (1 + (1 − 0.36) × (0.25))
= 0.9

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Question 10(b): Question and Solution

Question 10(b)
10(b). Would it make any difference if you knew that RJR Nabisco had a
much higher fixed cost structure than the comparable firms used here?

Yes. The higher fixed cost structure would lead us to use a higher
unlevered beta for Nabisco this would mean higher degree of
operating leverage

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Practical Problems

Practical Problems

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Comment (I): Estimation Period

Best Practice
What is the best practice for estimating equity beta? Or, what are the
caveats in the many different ways of estimating equity beta?

What should we consider?

Frequency: Tick-by-tick? Daily? Weekly? Monthly? Annually?
Estimation duration: 1 year? 3 year? 10 year? Expected holding
period?
What are the trades-off or caveats?
Small/finite sample bias
Possible regime shift
Computational power
What can you do?
Conduct a sensitivity analysis by comparing the beta estimators using
different estimation windows (and other asset pricing models, e.g.
Fama-French model)
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Comment (II): Different Methods

Quote from Your Colleague

In the practical, 10 students will have 11 answers!

What are some ways to value the market value of term debt?
Method 1: Use fair values
As of September 30, 2017 and September 24, 2016 , the fair value of
the Companys Notes, based on Level 2 inputs, was $106.1 billion and
$81.7 billion , respectively (p. 60)
Method 2: Make assumptions and use annuity formula
Method 3: ...
Go and explore! There is no right or wrong methods (while
they may differ in terms of rigor)

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Logistics Conceptual Practical: Comments Wrap Up

Comment (III): Assumptions and Reality

Best Practice
Validate your assumptions and check the facts.

Why do we make assumptions?

Arriving at an answer through abstracting away from minor details
What are good assumptions?
Should simplify analyses
Should be consistent with facts

Example: Assumptions vs Reality

Term debt details are provided up to 2022. Can we assume long-term debt
will mature one year after 2022, i.e. 2023, treat this portion as a terminal
value and discount it to the present?

Fact: In 4th Quarter 2017, Apple issued 3.75% notes maturing in 2047 (p.
59).
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Logistics Conceptual Practical: Comments Wrap Up

Wrap-up

Next week: Tips for coursework 2

Questions and Suggestions?

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