risk adjusted discount rate

sessiljoseph
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risk adjusted discount rate

Postby sessiljoseph » Mon Apr 28, 2014 7:19 am

the risk free rate for an investment is 5.55 and the market risk premium is 6% the beta value for the asset is 1.8 which has a capital structure of 60% debt with a default spread of 8% calculate the certanity equilavents for 2yrs based on the forecasted cashflow,historically the firm has declared a dividened of 104 which is forecasted to grow at 10% for the next 2 yrs

edupristine
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risk adjusted discount rate

Postby edupristine » Tue Apr 29, 2014 6:31 am

Could you please give the source of the question.

edupristine
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risk adjusted discount rate

Postby edupristine » Tue Apr 29, 2014 7:44 am

Certainty Equivalent (CE) = Dividend Paid*(1+Rf)^n/(1+WACC)^n
Dividend (0) = 104, Dividend (1) = 104*(1+10%) = 114.4, Dividend (2) = 114.4*(1+10%) = 125.84
WACC = d*Cost of Debt + e*Cost of Equity
d = 60% (given), e = 1-60% = 40%
Cost of Debt = Rf + Default Spread = 5.5% + 8%(please check this is quite high) = 13.5%
Cost of equity = Rf + Beta Levered*(Market Risk Premium)
Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))), Tax rate is not given, so we will take it as 0. Unlevered Beta = 1.8, Levered Beta = 1.8*(1+.6/.4) = 4.5.
Cost of Equity = 5.5 + 4.5*(6%) = 32.5%
WACC = 0.6*13.5 + 0.4*32.5 = 21.1%
CE(1) = 114.4*(1+5.5%)^1/(1+21.1%)^1 = 99.66
CE(2) = 125.84*(1+5.5%)^2/(1+21.1%)^2 = 95.51
Last edited by edupristine on Tue Apr 29, 2014 11:48 am, edited 1 time in total.

edupristine
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Postby edupristine » Tue Apr 29, 2014 11:14 am

If Dividend is 10$ instead of 104 and Risk premium is 0.8% (As given in the quiz)
Cost of Debt = 5.5 + 0.8 = 6.3%
WACC = 0.6*6.3+0.4*32.5 = 16.78%
CE(1) = 11*(1+5.5%)^1/(1+16.78%) = 9.93
CE(2) = 12.1*(1+5.5%)^2/(1+16.78%)^2 = 9.87


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