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##### Finance Web-based Exercises

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Question;13. Part B, Web-based Exercises;http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html In;prior Ch. 12 HW Part B, we find from online data source that the long-term;average expected return for US stock market (Rm) was xx.xx% per year, while the;long-term average expected return for US "risk-free" T-bill (Rf) was;xx.xx% per year. Furthermore, via Money MSN, under CAT's;Quote"==>""Financial Highlights" (just below where;you found CAT's "dividend rate" amount in Ch. 08 HW), we can find;CAT's systematic risk "Beta" value is given as x.xx.;(1) Use those given data from web sources, plug them into the;CAPM formula E(Ri) = Rf + BETAi * [E(Rm) - Rf], and calculate "what is;E(Ri), i.e., the fair expected or required return for CAT stock in market;equilibrium?;(2) Remember in Ch. 08 HW, how did we use "dividend growth;model", P0 = D0 * (1 + g) / (R - g), to calculate CAT's fair price in;market equilibrium? Well, back then the required return R is given;subjectively as either ?11.26%? or ?1.63%? (just as a matter of wild guessing).;Now, after studying Ch. 13, we know how to objectively estimate the expected or;required return as a matter of fact, e.g., by using the market-data-based CAPM;calculation answer for E(Ri).;Use your calculated E(Ri) from the aforementioned HW step (1);plug it as R into the dividend growth model formula, and recalculate "what;is P0, i.e., the fair price for CAT stock in market equilibrium?;Part B, Web-based Exercises;Please note: "cost of capital" is the same as;required return (i.e., expected return)" of capital, and;security market line" SML is the same as CAPM.);14. (1)According;tohttp://finance.yahoo.com, "Key;Statistics", what are the given values of CAT's;Market Cap (for equity)" E and "Total Debt" D;respectively? And thus what shall be CAT's "weight;of equity capital, We" and "weight of debt capital;Wd", respectively?;Hints: For example, if a firm?s reported ?Market Cap? is $75;billion, ?Total Debt? is $25 billion, then We = 75 bil / (75 bil + 25 bil) = 75;bil / 100 bil = 0.75 (or 75%), and Wd = 25 bil / (75 bil + 25 bil) = 25 bil /;100 bil = 0.25 (or 25%).;(2) Based on the aforementioned existing capital structure;weights, and the findings from previous chapter exercises;From Ch. 10 HW Part B, Application 1, we find that CAT's cost of;longest-term debt Rd (e.g., CAT's longest-maturity bond YTM) = 5.181% per year;From Ch. 10 HW Part B, Application 2, we find that when we use;dividend growth model DGM, CAT's cost of common stock equity Re (e.g., CAT;stock's required return) = 4.54% per year;From Ch. 13 HW Part B, we find when we use capital asset pricing;model CAPM, CAT's cost of common stock equity Re (e.g., CAT stock's required;return) = xx.xx% per year;Hints: Since neither DGM nor CAPM is perfect (the former uses;current data but ignores market risk, can't be applied on stocks that pay no;dividends, so it is "current but not stable", the latter;considers market risk but relies on outdated historical average data, can be;applied on stocks that pay or do not pay dividends, so it is "stable but;not current"), the best method to estimate Re shall be "the average;of both DGM and CAPM outcomes.;An applicable corporate tax rate is given as Tc = 35% (Federal;income tax only) for CAT.;Based;on the aforementioned data, compute CAT's WACC.;(3) Let's recall the prior exercises in Ch. 10;and see what the WACC shall be used for.;In;?HW for Chapter 10, Part B? Caterpillar exercises, we find that to finance;capital investment projects,using debt capital alone will cost relatively less;[particularly after multiplying yield-to-maturity Rd with (1 - Tax rate), with;tax deduction benefit on corporate debt interest expenses] but will increase;the bankruptcy risk, while using equity capital alone will lower the bankruptcy;risk but the cost of equity could be higher compared with the after-tax;cost of debt capital. So, the best way to finance an investment;project while keeping the firm's growth sustainable is to "use some debt;and use some equity, therefore keeping the existing debt-equity ratio constant;and not off-balance." As a result, the best required return (i.e.;discount rate, or cost of capital) for an investment project is the firm's;WACC, which is the weighted average of debt and equity capital!;Based on the required return (financing cost) of WACC we;calculate in Step (2), if CAT applies the IRR rule, shall CAT purchase the;order entry system described in Ch. 10, Ex. 14 or not?;Based on the required return (financing cost) of WACC we;calculate in Step (2), If CAT applies the NPV rule, what shall be the NPV;amount, and shall CAT purchase the order entry system or not?

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