Corporate Finance

Essay by baojiayuki September 2006

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Question 1.

A broker has advised you not to invest in oil industry stocks because, in her opinion, they are far too risky. She has shown you evidence of how wildly the prices of oil stocks have fluctuated in the recent past. She demonstrated that the standard deviation of oil stocks is very high relative to most stocks. Do you think this broker's advice is sound for a risk averse investor like you? Why or why not? Explain briefly.

Question 2

The Downtown Company has an equity beta, of 1.6 and 50% debt in its capital structure. The company has risk-free debt that costs 6% before taxes, and the expected rate of return on the market (including the value of imputation tax credits) is 18%. Downtown is considering the acquisition of a new project in the peanut-raising agribusiness that is expected to yield 15% on after-tax net operating cashflows.

The Carternut Company, which is in the same product line (and risk class) as the project being considered, has an equity beta, , of 2.2 and has 80% debt, that costs 10% before taxes, in its capital structure. If Downtown finances 50% of the new project with debt, should it be accepted or rejected? Assume that the effective tax rate for both companies is 25%.