Business Administration – Finance

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“Financial Options and Weighted Average Cost of Capital (WACC)” Please respond to the two (2) questions below.:

• Determine two to three (2-3) methods of using stocks and options to create a risk-free hedge portfolio. Support your answer with examples of these methods being used to create a risk-free hedge portfolio.
• From the scenario, create a unique hypothetical weighted average cost of capital (WACC) and rate of return. Recommend whether or not the company should expand, and defend your position.

Scenerio (reference material for answering question#2). FIN534_4_2_Don-1: I see you are here bright and early as usual.You and your intern have been doing fabulous work. We are looking for someone like your intern to come on board, but I would like to see your intern work on some more projects before we consider extending an offer..

FIN534_4_2_Linda-1: Of course, I understand Don. So far, our intern has done excellent work. Strayer University is really teaching its students well. Our intern has seemingly learned the concepts taught in class and has been able to apply here on the job. FIN534_4_3_Linda-1: Don, you mentioned some more work?

FIN534_4_3_Don-1: Yes, Linda. Since TFC went public, we have always considered our stockholder risk averse, as they want to see their investment grow but without a lot of risk. Based on the ratio analysis you showed me, it seems we have been doing just that. However, this expansion project is not revealing the same picture. When Joe talks to our investors, he wants to be able to explain why this project is good for TFC’s future even though financially, it may not seem like the best move. With that, I would like you and your intern to come up with the expected rate of return that our investors are currently benefiting from their equity. This will also be our required rate of return for the project, as we have to give the investors a return on their investment.

FIN534_4_3_Linda-2: Sounds great Don. Let’s go inside. I am going to meet the intern in the conference room to discuss our next project. FIN534_4_4_Linda-1: I just met with Don and he has given us another project. He asked that we calculate TFC’s expected rate of return, which is also the required rate of return for our stockholders. In order to do that we are going to use the Capital Asset Pricing Model, or CAPM. With the help of the Security Market Line, or SML, we will use inputs to calculate the required rate of return. In general the required rate of return for TFC will be a risk-free rate plus some additional market premiums. When we put it all together, we will come up with our required rate of return.

FIN534_4_4_Linda-2: Our formula can be thought of as the required rate of return for TFC is equal to the risk-free rate plus a risk premium for TFC’s stock. FIN534_4_5_Linda-1: In order for us to calculate the required rate of return, let’s go over all the components of the calculation.

FIN534_4_5_Linda-2: First, let’s look at the Risk-free rate. This is simply the rate on riskless securities and is commonly measured by the yield on long term U.S. Treasury bonds. It is based in the understanding that the U.S. government will not default on their obligations so the bonds are considered risk free.

FIN534_4_5_Linda-3: Next is the Market Risk Premium, or RP sub M. The Market Risk Premium can be thought of as the additional risk that comes with investing in a non-government security. This is that extra risk premium that is put on any security that is above the risk-free rate. From an investor’s standpoint, they want a premium on any investment that is not risk-free because they will be assuming the risk and the trade off is the higher the risk, the higher the return demanded. The RP sub M is the difference between what the market is returning and the risk free rate.

FIN534_4_5_Linda-4: And lastly is Beta, which is a measure of how much TFC’s risk would contribute to a well diversified portfolio. Typically stocks have a beta between zero point four and zero point six. FIN534_4_6_Linda-1: Now that we have our variables, let us determine what the expected value is. Before we do that, we need to call the Accounting Department to get some numbers from them, such as the beta for TFC and the risk free and market rates.

(Linda makes a phone call)

FIN534_4_6_Linda-2: This is Linda who is working on the expansion project and we would like to know the long-term U.S. Treasury bond rate, market portfolio rate, and TFC’s beta.

FIN534_4_6_Linda-3: (makes a quick laugh) It is something how once you mention the expansion project everyone stops what they are doing and gives you what you need.

FIN534_4_6_Linda-4: Accounting said that the long term bond rate is three percent, the market rate is eighteen percent and TFC’s calculated beta is point eight.

FIN534_4_6_Linda-5: I am going to the Accounting Department to personally thank them. While I am gone, can you calculate the required rate of return based on this data?