Recitation 16

Spring 2021

Question 1
Suppose there is a private shoe manufacturer called XYZ. XYZ is going public (doing an
initial public offering) and has hired an investment bank to assess the firm’s fair market
value. One of the key ingredients to the fair market value is the firm’s business risk.

The investment bank decides to use a comparable companies analysis, using publicly traded
shoe manufacturers to assess the business risk of such a business. Suppose the investment
bank was not able to find any “pure plays” (companies that only manufacture shoes), but
found two companies that manufacture both shoes and apparel, firms A and B. According
to the investment bank’s analysis, the firms betas (business risk) and percentage of business
in shoes vs. apparel are given below:
Firm Firm beta Shoe Apparel
A 0.9 40% 60%
B 0.7 70% 30%

Assume both firms are fully equity-financed (have no debt). Based on this information,
assess the business risk of the shoe manufacturer XYZ.

Solutions:
Let βS be the beta of a pure shoe manufacturing business, and βA be the beta of a pure
apparel manufacturing business. We know that βS represents the business risk for firm XYZ.
Since we know the market weights on shoes vs. apparel for firms A and B, we can represent
firm A and firm B as a portfolio of the pure-play shoe and pure-play apparel manufacturing
businesses in order to solve for βS and βA .

Firm A: 0.9 = 40%βS + 60%βA

Firm B: 0.7 = 70%βS + 30%βA

Solving this system of two equations with two unknowns yields βS = 0.5 and βA = 1.17.
Therefore, the beta for firm XYZ, a pure-play shoe manufacturing business, is βS = 0.5.

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Question 2
A private equity fund is considering buying a gold mining company, Kinross Gold. The firm
is expected to generate an after-tax cash flow of $540mm next year (Year 1). This cash flow
is expected to grow at 2.5% in perpetuity. The private equity fund needs to determine the
cost of capital for Kinross Gold in order to estimate its value.
Suppose that asset returns are characterized by a two-factor model:
ri = E[ri ] + βi,1 f1 + βi,2 f2 + i
The first risk factor is the market risk, and the second risk factor is the price of gold.
You have estimated factor loadings for Kinross Gold and found that its loading on the
market risk is 0.3, and its loading on the gold price risk is 1.92. In order to estimate Kinross
Gold’s cost of capital, you have obtained the following information on three well-diversified
portfolios, A, B, and C:
Portfolio E[ri ] βi,1 βi,2
A 4% 0.0 1.0
B 6% 0.5 0.5
C 4% 0.5 -0.5
What price should the private equity fund be willing to pay in order to buy Kinross Gold?
Assume that Kinross Gold is all equity-financed (has no debt on its balance sheet).

Solutions:
The value of Kinross Gold can be found using the Gordon Growth model:
F CF1
V0 =
r−g
$540mm
V0 =
r − 2.5%
To find the value of the firm, we need to find r, its cost of capital.
Recall the APT pricing equation:
E[rp ] = rf + λ1 βP,1 + λ2 βP,2
We can write down this pricing equation for all three portfolios.
A: 4% = rf + λ1 × 0 + λ2 × 1
B: 6% = rf + λ1 × 0.5 + λ2 × 0.5
C: 4% = rf + λ1 × 0.5 + λ2 × (−0.5)
This a system of three equations with three unknowns. Solving yields rf = 2%, λ1 = 6%,
λ2 = 2%.
So, the expected return on Kinross Gold is:
E[r] = 2% + 6% × 0.30 + 2% × 1.92 = 7.64%
Substituting r = 7.64% yields the following value of Kinross Gold:
$540mm
V0 = = $10.51bn
7.64% − 2.5%

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Question 3
Consider an asset with a price linked to the price of crude oil. Suppose the current price of
crude oil is $55 per barrel. Assume the risk-free rate rf = 2%.

(a) Suppose the asset in question pays in Year 5 the realized price of oil in Year 1. What
is the asset’s current value?
(b) Suppose the asset in question pays in Year 5 the realized price of oil in Year 2. What
is the asset’s current value?
(c) Suppose the asset has a Year 5 payoff of P1 +P32 +P5 , where Pi is the realized price of
oil in year i. What is the asset’s current price?

Solutions:
(a) We can start by thinking about what the price of the asset would be in year 1. Between
now (year 0) and the end of year 1, the price is uncertain. However, between year 1
and year 5, the asset payoff is certain, so the asset is therefore risk free. Let P1 be the
price of oil in year 1, which is what the asset will pay off in year 5. At the end of year
1, P1 is known. So, the value of the asset in year 1 is:
P1
Value1 =
(1 + rf )4

Now, we consider the value of the asset at year 0. At year 0, we don’t know what the
price of oil will be at the end of year 1. Let r̄0 be the annual expected return on oil.
We will assume this stays constant over all time horizons (the term structure of these
rates are flat). The value of the asset in year 0 is then the expected value of the asset
in year 1, discounted at r̄0 to reflect the riskiness of the asset between year 0 and year
1:
E[Value1 ]
Value0 =
(1 + r̄0 )
E[P1 /(1 + rf )4 ]
=
(1 + r̄0 )
E[P1 ]
=
(1 + r̄0 )(1 + rf )4
P0 (1 + r̄0 )
=
(1 + r̄0 )(1 + rf )4
P0
=
(1 + rf )4

$55
Since rf = 2% and P0 = $55, the value of the asset at Year 0 is (1+.02)4 = $50.81.

(b) We start by thinking about the price of the asset in year 2, once there is no uncertainty
around the asset’s year 5 payoff. The value of the asset in year 2 is:
P2
Value2 =
(1 + rf )3

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 We now consider year 0. Again, we assume the annual expected return on oil r̄0 stays
constant over all time horizons. The value in year 0 is the expected value of the asset
in year 2, discounted to year 0 at r̄0 to reflect the riskiness of the asset between Year
0 and 2:
E[Value2 ]
Value0 =
(1 + r̄0 )2
E[P2 /(1 + rf )3 ]
=
(1 + r̄0 )2
E[P2 ]
=
(1 + r̄0 )2 (1 + rf )3
P0 (1 + r̄0 )2
=
(1 + r̄0 )2 (1 + rf )3
P0
=
(1 + rf )3

$55
So, the value of the asset in year 0 is 1.023 = $51.83.
(c) We can construct this asset’s payoff with a portfolio of assets paying P1 in Year 5, P2
in Year 5, and P5 in Year 5, each with a 1/3 weight. We have the values of the first
two assets from part a and b, so we must now find the value of the asset that in year
5 pays P5 .
The value of such an asset in year 5 is simply the price of crude oil in year 5, P5 .
Then, the value at year 0 is:
E[Value5 ]
Value0 =
(1 + r̄0 )5
E[P5 ]
=
(1 + r̄0 )5
P0 (1 + r̄0 )5
=
(1 + r̄0 )5
= P0
= $55

P1 +P2 +P5
So the value of the asset with a payoff of 3 in year 5 is:
1 1 1
× $50.81 + × $51.83 + × $55 = $52.55
3 3 3

Question 4
Consider a firm which operates as a restaurant. The restaurant is expected to generate an
after-tax cash flow of one million dollars next year (Year 1). This cash flow is expected to
grow at a 2% annual rate in perpetuity.
Next year (Year 1), the firm will have an opportunity to open a new restaurant. If this
restaurant is opened, it will start generating exactly the same cash flow as the first restaurant
in Year 2.

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Note: the first restaurant will generate 1.02 million in year 2. If the second restaurant is
built, it will generate 1.02 million in cash flow that year as well.
There is uncertainty with respect to the investment costs needed to open the new restaurant
next year. Depending on the state of the economy and availability of retail space, these costs
can be either $5mm (20% probability) or $15mm (80% probability).
Assume that the appropriate discount for the restaurant business is 12%. What is the
present value of this growth opportunity?

Solutions:
We start by determining the optimal decision in Year 1 - should the firm open the second
restaurant?

Case 1: opening costs are $5mm. We are in Year 1. Should we open the restaurant?
If we open the new restaurant, the firm value will be
$1.02mm × 2
V1 = −$5mm +
r−g
$1.02mm × 2
= −$5mm +
12% − 2%
= $15.4mm

If we don’t open the new restaurant, the firm value will be

$1.02mm
V1 =
r−g
$1.02mm
=
12% − 2%
= $10.2mm

So, if opening costs are $5mm, the optimal decision is to open the new restaurant. In this
scenario, the firm value in year 1 is $15.4mm.

Case 2: opening costs are $15mm. We are in Year 1. Should we open the restaurant?
If we open the new restaurant, the firm value will be
$1.02mm × 2
V1 = −$15mm +
r−g
$1.02mm × 2
= −$15mm +
12% − 2%
= $5.4mm

If we don’t open the new restaurant, the firm value will be

$1.02mm
V1 =
r−g
$1.02mm
=
12% − 2%
= $10.2mm

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So, if opening costs are $15mm, the optimal decision is to not open the new restaurant. In
this scenario, the firm value in year 1 is $10.2mm.

We now consider the value of the firm in year 0:

F CF1 V1
V0 = +
(1 + r) (1 + r)
Weighting the value of the firm under optimal deciion making in year 1, we have:
$1mm 20% × $15.4mm + 80% × $10.2mm
V0 = +
(1 + 12%) (1 + 12%)
= $10.93mm
The value of the growth option is the firm value with the growth option minus the firm
value without the growth option. We have the value of the firm with the growth option, so
we now must compute the value without the growth option:
$1mm $1mm
No growth option V0 = = = $10mm
(r − g) 12% − 2%
So the value of the growth option is:

P V (GO) = $10.93mm − $10mm = $0.93mm

Question 5
Kinross Gold is considering acquiring a gold mine in Russia. The estimated reserves are
one million ounces. It takes one year to extract gold, and the estimated extraction costs are
$1,000 per oz.
The current price of gold is $1,200 / oz. It will either increase to $1,600 per oz or decrease
to $900 per oz next year, and will stay at that level forever.
The risk-free rate is 2%. The gold price risk is not diversifiable.

(a) What is the value of this mine of extraction starts today?

(b) If Kinross Gold can wait for a year to start the extraction process and they can also
abandon this mine, what is its current value?
(c) What is the value of the abandonment option?

Solutions:
(a) Since the gold price risk is not diversifiable, we can’t discount at the risk-free rate.
However, we are not given the discount rate. To solve this problem, we will use the
prices of traded assets to obtain state prices, then use state prices to find the value of
the mine.

The current price of gold is $1,200 per oz. In the up state, the price goes to $1,600. So
$1, 600 = u × $1, 200 → u = 1.33. In the down state, the price goes to $900. Similarly,
we have d = 900/1200 = 0.75.

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 We can then find the risk-neutral probabilities of the up and down states using u and
d:
(1 + rf ) − d 1.02 − 0.75
qu = = = 0.463
u−d 1.33 − 0.75
u − (1 + rf ) 1.33 − 1.02
qd = = = 0.537
u−d 1.33 − 0.75

The state prices then follow from the risk-neutral probabilities:

qu
φu = = 0.454
(1 + rf )
qd
φd = = 0.527
(1 + rf )

With the state prices, we can find the present value of revenue if we start extraction
today. Recall that it takes one year to finish the extraction. The expected revenue per
oz of gold is $1, 600φu + $900φd = $1, 200. This is unsurprising, since the expected
value should equal the current price of gold.
The cash flow per ounce of gold is $1, 200 − $1, 000 = $200 per oz. So the value of the
mine is $200 per oz × 1mm oz = $200mm.
(b) Here, we can delay extraction for one year and abandon the mine if needed. In the
up state, we have a a positive cash flow per oz of gold ($1, 600 − $1, 000 > 0), so we
choose to extract. In the down state, we abandon the mine since the cash flow per oz
of gold is negative.
The following diagram demonstrates the timeline under this scenario:

The value in the up state, where you pay $1,000 per oz in year 1 and receive $1,600
per oz with certainty starting in year 2, is −$1, 000 + 1600
1.02 = $568.63. So, the current
value of this mine per oz is:

$568.63 × φu + $0 × φd = $258.03

So the value of the mine is $258.03 per oz × 1mm oz = $258.03mm.

(c) The value of the abandonment option is the value of the mine with the option minus
the value of the mine without the option. We have the value of the mine with the

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option, which we found in the previous part - it is $258.03mm. Now, we need to find
the value without the abandonment option.
To isolate the value of the abandonment option, we must separate its value from the
value of the option to delay production by a year. We do this by considering the case
where the firm can delay production but can’t abandon the mine:
In the up state, we still have a value of $258.03 per oz.
In the down state, rather than 0, we now have a value of −$1, 000 + $900
1.02 = −$117.65.
So the value per oz without the abandonment option and delaying production by a
year is:
$258.93 × φu − $117.65 × φd = $196.08

So the value of the mine if we delay production by a year and don’t have the abandon-
ment option is $196.08mm. Recall from part a that the value of the mine without the
abandonment option and starting extraction now is $200mm, which is greater than
$196.08mm. It is therefore optimal to start producing now if the abandonment option
is not available (the firm will not exercise the option to delay production), so the firm
value without the abandonment option is $200mm.
We have that:

- The value of the mine with the abandonment option is $258.93mm

- The value of the mine without the abandonment option is $200mm, since the
firm will choose to start producing now if it can’t abandon the mine
So the value of the abandonment option is then $258.93mm − $200mm = $58.03mm.