FIN 361 Fall 2023 Problem Set 2 Question 5 [20 points] Assume that currently US Treasury Bonds have a yield of 2.1%. a) b) From 2018 to 2023, the annual market returns were -6%, 29%, 16%, 27%, -19%, and 24%. During the same years Tesla's annual stock returns were 7%, 37%, 731%, 46%, -68%, and 110%. What is the equity beta and expected equity return of Tesla using these six years of data? (Hint: calculate the covariance between Tesla's stock and the market to find Tesla's equity beta. You may want to use Excel.) In mid-2023 Ford decides to expand their operations into electric vehicles. As a comparable company, the CEO of Ford has identified Tesla, which currently has a Debt- to-Equity Ratio of 2. Ford's stock price is $10 per share, with 4 billion shares outstanding. Ford also has $150 billion in outstanding corporate debt, with an average credit rating of BBB- and a debt-beta of 0.1. Assume that Tesla's cost of debt capital is 4.44%. Tesla's equity beta is the same as in part (a). First, find the debt-beta and the asset-beta of Tesla. Then, determine the appropriate after- tax WACC for Ford's expansion project if the company will be subject to a 21% corporate tax rate. Note: Show your work (an excel spreadsheet is fine, but also write down the answers clearly on your write-up). Question 6 [20 points] Suppose there are two firms, Eggland and Figbar. Both firms have the same cash flows in year 1: $275M if the economy is strong, and $150M if the economy is weak. Both scenarios are equally likely. The firms are identical except for their capital structure. Eggland is unlevered (i.e., has no debt) and has 5M shares outstanding which are currently trading at a market price of $41. Figbar has corporate bonds outstanding with a market value of $100M and a credit rating of AAA, as well as 10M shares at a current market price of $10. You can ignore taxes (except for in part f). a) What is the market capitalization and D/E ratio of Eggland and Figbar? b) Does M&M proposition 1 hold? Explain in your own words. ) Suppose you can borrow at the risk-free interest rate of 5%. Is there an arbitrage opportunity available using homemade leverage? If yes, present a detailed strategy to exploit the arbitrage opportunity. (Write down which securities equity and debt you would buy and sell and which quantities and show how they create an arbitrage opportunity). d) What is the expected rate of return of Figbar's equity? e) What is going to happen to Eggland's and Figbar's stock prices if many traders execute the arbitrage strategy you proposed in (c)? Explain in your own words. f) Figbar plans to roll-over its $100M in debt in perpetuity. Now assume Figbar pays a corporate tax rate of 25%. What is the present value of Figbar's interest tax shield? Note: Show your work