An equity analyst at a major Hong Kong investment bank is a specialist on the freight industry. She has been following a company that appears to maintain a target debt/equity ratio of 0.25. For example, it currently has long-term debt with a market value of $149.81 million and 10 million shares selling at $59.92 per share.

The analyst is curious to know how a change in the market risk premium will affect the share price. She has determined that the firm's debt has a CAPM beta coefficient of 0.19, while the CAPM beta for it's shares is 0.97. The current annual return on T-Bills is 2.25%, while the current market risk premium is 6.30%.

(a) Calculate the expected returns on the firm's debt and equity (to the nearest hundredth of a percent) implied by CAPM.

The firm has a stable EBIT of 74.75 million annually, while the current corporate tax rate is 28%.

(b) Verify that the shares appear to be appropriately priced using the FTE approach to valuing the firm's equity.

(c) Now use the model to predict the percentage change in the market value of equity if the market risk premium increases by 10% (to 6.93%) holding the risk-free interest rate constant?

[Hint: A change in the required rates of return will change the market values of debt and equity and the firm will respond by adjusting debt and equity outstanding to retain the desired debt/equity ratio of 0.25.]

Answer rating: 100% (QA)

a To calculate the expected returns on the firms debt and equity implied by the CAPM well use the fo... View the full answer