United Petroleum (UP), a diversified oil company, is considering taking over Deepwater Exploration Corp. (Deepwater), an offshore exploration company. You are the financial analyst of UP and are asked to collect historical data on the risk-free rates and the market risk premiums. Your estimates as of January 2050 are summarized as follows:

	Mean, annualized
Estimation period	Risk-free rate		Market risk premium
Oct 2049-Dec 2049	0.05		0.00
Jan 2020-Dec 2049	0.07		0.06

Answer questions (a) and (b) below.

1. Determine the risk-free rate and the market risk premium that are appropriate to use for the CAPM equation. Provide the rationale for your choice (approx. 100 words). (Lecture notes pp.21-24)

Answer (with justification):

2. Suppose the unlevered asset betafor the offshore exploration businessis estimated at 1.30. Additionally, assume that UP's leverage ratio of 25% (equivalently a debt-to-equity ratio of 1/3), its debt beta of 0.1, and a marginal tax rate of 40% will apply to the Deepwater acquisition project.Find the weighted average cost of capital (WACC) for the acquisition. (Lecture notes pp.37-41) *In case you are unsure about your results in part (a), assume in your CAPM calculation that the risk-free rate equals 10% and the market risk premium 10%.

Answer (show the steps/calculation toward your results):

Answer rating: 100% (QA)

Part a Choosing the Appropriate RiskFree Rate and Market Risk Premium Rationale The CAPM equation es... View the full answer