Question

A bio-technology company is looking to invest $25 billion in new technology that is expected to produce incremental cash flows of $7 billion, $10 billion, and $12 billion in each of the next three years, respectively. The CFO has asked that you and your team determine whether or not the company should invest in the new technology. In order to finance the project, the company will issue new bonds and new equity.

Of the $25 billion in costs, $16 billion will be financed with a new debt issue. In fact, the company is anticipating issuing two different bonds – short-term bonds and long-term bonds. Half of the $16 billion in debt capital will be raised with the short-term bond issue while the other half will be raised with the long-term bond issue.

Of the $25 billion in costs, $9 billion will be financed with new equity. Given this information, your objective is to calculate the weighted average cost of capital that then determine whether the future cash flows (in present value terms) are greater than the $25 billion investment.

QUESTION: The bio-tech firm will also issue new equity. The standard for the company has been to use the CAPM to determine the cost of equity. Since you’ve taken Fin 3200, you know you need to find the beta, the risk-free rate, and the expected return on the market in order to calculate the expected return, which will proxy for the cost of equity. You have found that the yield on 3-month T-bills is 3.1%. You have also gathered historical data on market returns. You have found that over the last 4 years, the market has returned 14%, 19%, 8%, and 10%. You have also found that the returns for the bio-tech firm have a covariance with market returns of .0030. Given this information, what is the firm’s cost of equity according to the CAPM? (Hint: you can use historical market returns to estimate expected returns for the market. You can also estimate the variance (or the standard deviation squared) of market returns to help you get beta… Please use decimals when calculating the variance of market returns and round to the 4th decimal place).

Group of answer choices

14.0%

18.9%

14.8%

17.1%

13.2%

15.4%

12.8%

19.9%

Answer 1

cost of equity = risk free rate + (beta * (expected market return - risk free rate))

expected market return = average of last 4 years returns

Variance of market return is calculated using VAR.S function in Excel

Beta = covariance of stock with market returns / variance of market return

risk free rate is the T-bill yield

cost of equity = 15.4%