1. [Inflation and Risk Premiums] Voice River, Inc.

, provides media-on
demand services via the Internet. Management has been studying current
interest rates. A lender is willing to make a two-year loan to Voice River at
a 12 percent annual interest rate. The U.S. government is currently paying
8 percent annual interest on its two-year securities.
From Question, Risk Free Interest Rate (rf) = 8%
Nominal Interest Rate (rd) = 12%
A. If the real rate of interest is expected to be 3 percent annually, what is the
inflation premium expected at this time?
Solution: Given,
Real Rate of Interest (RR) = 3%
Inflation Premium (IP) = ?
We know that, rf = RR + IP
So, IP = rf - RR = 8% - 3% = 5%

B. What is the amount of the total risk premium that Voice River will have to
pay?
Solution: Total Risk Premium (TRP) = rd -rf = 12% - 8% = 4%

C. If a 1 percent liquidity premium is built into the 12 percent rate, what is the
default risk premium on the loan?
Solution: Given,
Liquidity Premium (LP) = 1%
Default Risk Premium (DRP) = ?
We know that, Total Risk Premium (TRP) = LP + DRP
So, DRP = TRP - LP = 4% - 1% = 3%
2. [Maturity and Default Risk Premiums] Following is interest rate information
currently being observed by the Electronic Publishing Corporation:
One-year U.S. government securities 4.5%
One-year bank loans 6.0%
Five-year U.S. government securities 7.0%
Five-year bank loans 9.5%
A. What is the amount of the maturity risk premium on one-year versus five
year U.S. government securities?
Solution: We Know that,
Maturity Risk Premium = Government Securities Interest Rate (5year - 1 year)
So, MRP (on 1-year vs 5-year) = 7% - 4.5% = 2.5%
B. What is the amount of the maturity risk premium on one-year versus five
year bank loans?
Solution:We Know that,
Maturity Risk Premium = Bank Interest Rate (5year - 1year)
So, MRP (on 1-year vs 5-year) = 9.5% - 6% = 3.5%
C. What is the default risk premium on one-year bank loans and on five-year
bank loans?
Solution: We know that,
Default Risk Premium (DRP) = Bank Rate - Government Securities
DRP on 1-yr bank loan = 6% - 4.5% = 1.5%
DRP on 5-yr bank loan = 9.5% - 7% = 2.5%

3. [Expected Rate of Return and Risk Measures] A venture investor, BKAngel,

is considering investing in a software venture opportunity. However, the rate of
return to be realized next year is likely to vary with the economic climate that
actually occurs. Following are three possible economic outcomes, the
probability that each one will occur, and the rate of return projected for each
outcome:
 ECONOMIC PROBABILITY OF RATE OF
CLIMATE OCCURRENCE RETURN
Recession 0.25 -20.0%
Normal 0.50 15.0%
Rapid growth 0.25 30.0%

A. What is the expected rate of return on the software venture?

Solution: We know that,
Expected rate of return = rate of return * probability of occurrence
i.e. re = RR * p
From question, re = (RR * p) recession + (RR * p) normal +(RR * p)rapid growth
So, re = (.25 * -20) + (.5 * 15) + (.25 * 30) = 10%
B. Calculate the variance and standard deviation of the rates of return for the
software venture.
Solution: We know that,
�������� ��������� √�������� √337.5
Co-eff. of Variation = �������� ������
= �������� ������ = 10
= 1.837

C. Calculate the coefficient of variation of the rates of return for the software
venture. If the coefficient of variation of the rates of return for Bk Angel's prior
venture investments is 1.5, would the software venture be considered as being
less or more risky?
Solution: We know that,
�������� ��������� 18.37
Co-eff. of variation = �������� ������
= 10
= 1.84
The coefficient of variation after investment is greater than that before
investment which shows more risk associated with the investment over the
various economic climate and their reaction towards the venture. So, a high
risk-averse investor would back-off from the idea of investment whereas a high
risk taker would try his luck and invest despite the risks involved.
4. [Expected Rate of Return and Risk Measures] A potential venture investment
has the following possible outcomes:
PERFORMANCE PROBABILITY OF RATE OF
OUTCOME OCCURRENCE RETURN
Home run (success) 0.15 500.0%
Break-even 0.35 15.0%
Strikeout (failure) 0.50 -100.0%
A. What is the expected rate of return on the venture?
Solution: We know that,
Expected rate of return = rate of return * probability of occurrence
i.e. re = RR * p
From question, re = (RR * p) Home run + (RR * p) Break-even +(RR * p)Strikeout
So, re = (.15 * 500) + (.35 * 15) + (.50 * -100) = 30.25%
B. Calculate the variance and standard deviation of the rates of return for the
venture.
Solution: We know that,
�������� ��������� √�������� 188.72
Co-eff of Variation = �������� ������
= = = 6.24
�������� ������ 30.25
C. Calculate the coefficient of variation of the rates of return for the venture. If
the coefficient of variation of the rates of return for your prior venture
investments is 4.0, would the new venture be considered as being less or more
risky?
Solution: We know that,
�������� ��������� 188.72
Co-eff. of variation = �������� ������
= = 6.24
30.25

The coefficient of variation after investment (i.e. 6.24) is greater than that
before investment (i.e. 4.0) which shows more risk associated with the
investment over the various performance outcome and their reaction towards the
venture. So, a high risk-averse investor would back-off from the idea of
investment whereas a high risk taker would try his luck and invest despite the
risks involved.
5. [Portfolio Expected Rate of Return and Risk Measures] Three venture
investments previously made by BKAngel, a venture investor, achieved the
following outcomes for the year just completed:
VENTURE INITIAL CASH ENDING
OPPORTUNITY VALUE FLOW VALUE
VENTURE 1 $ 300000 $ 75000 $ 600000
VENTURE 2 $ 400000 $ 50000 $ 300000
VENTURE 3 $ 300000 - $ 60000 $ 360000
A. Calculate the percentage rate of return for each of the venture investments.
Solution: We know that,
���� ���� + ������ ����� − ������� �����
% Rate of Return =
������� �����

B. Calculate the expected rate of return for a portfolio of these three venture
investments weighted by each venture’s investment share of a total $1 million
investment.
Solution: We know that,
Expected Rate of return = rate of return * probability of occurrence
i.e. re = RR * p
From question, re = (RR * p)Venture 1 + (RR * p)Venture 2 +(RR * p)Venture 3
So, re = (0.3 * 125) + (0.4 * -12.5) + (0.3 * 0) = 32.5%
C. Calculate the variance and standard deviation of the rates of returns for the
portfolio investment.
Solution: Process similar to Q no. 4
D. Calculate the coefficient of variation of the rates of returns for the portfolio
investment. Is this portfolio investment less or more risky than another
investment opportunity with a coefficient of variation of 1.5?
Solution: Process similar to Q no. 4
7. [Loan Present Values] Jerry’s Tree Services is trying to raise debt funds
from a prospective venture investor, SureWay LLC. SureWay indicated to
Jerry Lau that the annual interest rate on risky venture loans is currently
15 percent. Jerry is seeking a three-year loan with annual payments. He is
willing to pay back $100,000 at the end of three years. However, because of
cash flow problems, he can afford to pay interest at only a 12 percent
annual rate.
Given, Future Value (FV) = $100000
Annual Interest Rate (i) = 15%
Rate of Interest (ks) = 12%
Payment Amount (PMT) = g * FV = $12000
�� $100000
Present Value (PV) = (1+��) = (1+0.12)^3 = $ 71178.03
^�

A. Calculate the dollar amount that SureWay venture investors would lend to
Jerry’s Tree Services.
Solution:
B. What would be the dollar amount of the loan if the loan is made for only two
years?
9. [Expected Rate of Return and Hubris Premiums] Following is the rate-
of-return component information for FirstVenture investors:

RATE COMPONENT RETURN COMPONENT

Liquidity premium 5.5%
Risk-free rate 5%
Advisory premium 9%
Investment risk premium 11.5%
Target rate of return 40%
A. Calculate the expected rate of return before considering premiums for
illiquidity, advisory activities, and hubris projections.
Solution: We know that,
Expected Rate Of Return = Risk Free Rate + Investment Risk Premium
= 5% + 11.5% = 16.5%
B. Estimate the hubris projections premium for this FirstVenture
investment.
Solution: We know that,
Hubris Projections Premium = Target rate of return - Expected Rate Of
Return - Liquidity premium - Advisory premium
= 40% - 16.5% - 5.5% - 9% = 9%
10. [Cost of Equity Capital] Use the following information to estimate the
VentureBanc investors’target rate of return:

RATE COMPONENT RETURN COMPONENT

Liquidity premium 5%
Risk-free rate 6%
Advisory premium 9%
Market risk premium 7.5%
Hubris Projections Premium 15%

A. VentureBanc uses a systematic risk measure of 2.0. Based on the

information shown, estimate VentureBanc’s investment risk premium. Then
estimate the cost of equity capital for VentureBanc.
Solution: Given, Systematic Risk Measure ( β ) = 2.0
We know that,
Investment Risk Premium = MRP * β = 7.5% * 2 = 15%
Hubris Projections Premium = Target rate of return - Expected Rate Of
Return - Liquidity premium - Advisory premium
B. Determine the rate components and their returns that a venture investor like
VentureBanc would require to be covered beyond a traditional cost-of-equity
estimate.
Solution: We know that,

C. What overall venture investment discount rate would be used by

VentureBanc?
Solution:
11. [Weighted Average Cost of Capital] Kareem Construction
Company has the following amounts of interest-bearing debt and
common equity capital:
Financing Dollar Interest Cost of
Source Amount Rate Capital
Short-term loan $200000 12%
Long-term loan $200000 14%
Equity Capital $600000 22%
Total Amount $100000
Kareem Construction is in the 30 percent average tax bracket.
A. Calculate the after-tax WACC for Kareem.
Solution: We know that,
After-tax WACC = [(Short-term loan) x (1-Tax Rate) x (Short-term debt to value)] +
[(Long-term loan) x (1-Tax Rate) x (Long-term debt to value)] +
[(Equity Capital) x (Debt to Value)]
= [ 12% x ( 1- 0.30) x 0.2] + [ 14% x ( 1- 0.30) x 0.2] + [ 22% x 0.6]

= 1.68 + 1.96 + 13.20 = 16.84%

B. Show how Kareem’s WACC would change if the tax rate dropped to 25
percent and the estimated cost of equity capital were based on a risk-free
rate of 7 percent, a market risk premium of 8 percent, and a systematic risk
measure or beta of 2.0.
Solution: Given,
Tax Rate (T) = 25%
Risk-Free Rate (rf) = 7%
Market Risk Premium (MRP) = 8%
Systematic Risk Measure (β) = 2.0
We Know that, Cost of Capital (re) = rf + MRP * β = 7 + 8*2 = 23%
 WACC = [(Short-term loan) x (1-Tax Rate) x (Short-term debt to value)] +
[(Long-term loan) x (1-Tax Rate) x (Long-term debt to value)] +
[(Equity Capital) x (Debt to Value)]
= [ 12% x (1 - 0.25) x 0.2] + [ 14% x (1 - 0.25) x 0.2] + [ 23% x 0.6 ]
= 1.80 + 2.10 + 13.80 = 17.70%

12. [CAPM Estimate of Cost of Equity Capital] Voice River, Inc., has
successfully moved through its early life cycle stages and now is well into its
rapid-growth stage. However, by traditional standards this provider of
media-on-demand services is still considered to be a relatively small
venture. The interest rate on long-term U.S. government securities is
currently 7 percent. Voice River’s management has observed that, over the
long run, the average annual rate of return on small-firm stocks has been
17.3 percent, while the annual returns on long-term U.S. government
securities has averaged 5.7 percent. Management views Voice River as
being an average small-company venture at its current life cycle stage.
Given,
Interest Rate on Long-Term U.S. Government Securities (Hrr) = 7%
Historical Average Annual Rate of Return on Small-Firm Stocks (Hahr)= 17.3%
Historical Average Annual Returns on Long-Term U.S. Government Securities
(Hrfr)= 5.7%
A. Determine the historical average annual market risk premium for small-
firm common stocks.
Solution: We know that,
Historical Average Annual Market Risk Premium = Historical Average Annual
Rate of Return on Small-Firm Stocks - Average
Historical Risk Free Rate
Or, Hmrp =Hahr - Hrfr = 17.3% - 5.7% = 11.6%
B. Use the CAPM to estimate the cost of common equity capital for Voice
River.
Solution: Given,
CAPM = Risk Free Rate + Average Annual Market Risk Premium * β
= Hrr + Hmrp * β =

13. [Weighted Average Cost of Capital] Voice River, Inc., is interested in

estimating its WACC now that it is in its rapid-growth stage. Voice River
has a $500,000, 10 percent interest, short-term bank loan; a $1.5 million, 12
percent interest, long-term debt issue; and $42 million in common equity.
The venture is in the 35 percent income tax bracket.
A. Determine the after-tax costs of the bank loan and the long-term debt
issue.
Solution: Given,

B. Calculate the WACC for Voice River, Inc., using the cost of common
equity capital estimated in Problem 12.
Solution: Given,
14. [Weighted Average Cost of Capital] Refer to Problem 13 for Voice
River, Inc.
A. Estimate the WACC if the cost of common equity capital is 20 percent.
Solution: Given,

B. Estimate the WACC if the cost of common equity capital is at the

representative target rate of 25 percent for typical ventures in their late
rapid-growth life cycle stage.
Solution: Given,