🙋 Student Questions and Answers

Click here to learn about timestamps and my process for answering questions. Section agendas can be found here. Email office hour questions to robmgmte2700@gmail.com. PS1Q2=“Question 2 of Problem Set 1”

📅 Questions covered Saturday, April 13

PS8Q3

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❔ Should we assume the expected cash flow should be the midpoint between weak and strong? Can you clarify the table also? I am using the one in slide 22 as a reference and still not sure the order of the one in the problem.

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Risk Premium vs Unlevered Cost of Capital

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❔ Is unlevered cost of capital the risk premium?

✔ Unlevered cost of capital and risk premium are different concepts.

Unlevered Cost of Capital is the rate of return that investors will demand on a project that has no debt. It is, therefore, the expected return that equity investors must be paid if the firm has no debt. In other words, it is the expected return for equity investors. Usually we calculate the expected return for unlevered equity investors by calculating the expected value of the assets one year from now and using that to calculate the expected value of equity one year from now. If we have the current value of equity, we can calculate the expected return on equity by using the percentage growth formula:

$$\%Growth = \frac{New-Old}{Old}$$

If we calculate the % growth (ie the expected return) for the unlevered equity, we get:

$$E(r_u)=\frac{E(E_1)-E_0}{E_0}$$

As explained above, the unlevered cost of capital is equal to the expected return on unlevered equity. Note that to understand this material and to do well on this exam, you will need to fully understand and be able to recall each step in the above argument. Start learning it now, and after another section and having worked through the homework on your own, you will be well on your way!

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❔ Question 6: There appears to be a significant part of the question missing from the body of the problem.

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❔ Question 8: I believe the risk free rate for debt is required for this problem to calculate the expected interest but it was not included. Please confirm if this is the case?

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❔ Question 5: Can you provide an example of a similar question on Saturday

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📅 Questions covered Monday, April 15

🕣 8:12
❔ Is it possible to cover PS8 Q5 (d) in Monday’s section? Also, if you can discuss Q8 then that woudl help. Specifically, if you can just discuss the steps with formula to be used then that will be very helpful.

✔ I will definitely cover question 8 tonight. Regarding question 5, basically, for that question you have to calculate all of the numbers in the following table from the slides: image.png (image taken from slide 22 of lecture 10)

This is a very complex question. To understand it and approach it, you really need to have watched my section from Saturday. Have you had a chance to watch it yet? Basically, I have already provided all of the steps in that recording when we reviewed the coffee shop example. For reference, here is the Excel spreadsheet: https://2700.netlify.app/l10/coffeeshop/

In general, I have very significant reservations about going through a problem step-by-step and telling you which formulas to use. It is of questionable ethics, and it also gives you an illusory sense that you have mastered the material. Attempting to complete the homework like that without deeply understanding the material is a sure recipe for getting a low score on the exam. It is much more in your interest to watch or rewatch the Saturday section, make sure that you understand all of the steps in the coffee shop example, and then ask me about the steps that you don’t understand. Once you can do this, problem 5 will be much more straightforward because you will be well prepared. You will be able to ask more precise questions about any sticking points that I will be happy to answer. Finally, you’ll do far better on the exam.

Here is a link to the spreadsheet from Saturday. It contains formulas to calculate every single cell of the table I shared above: https://2700.netlify.app/l10/coffeeshop/

Here’s another example that may prove helpful: https://2700.netlify.app/l10/2ndmmproblem/

The key thing, by far, is to (re)watch the section from Saturday and make sure you understand it, though.

The same example is summarized here: https://2700.netlify.app/l10/coreexample/ This will complement the spreadsheet.

🕣 8:31 pm
❔ Could you also go over perfect market vs imperfect market?

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A perfect capital market is a market in which:

• Securities are fairly priced
  • You can always buy or sell any security for the present discounted value of the Expected Value of the future cash flows. For example, to calculate the value of the unlevered equity in the coffee shop, we calculate the Expected value of the FCF = 50%*42K + 50%*27K=34.5K. Then we take the present value of that. V_U=$34.5/(1+15%)^1 = 30K No tax consequences or transactions costs
  • you can sell every security and receive the its value without paying a transaction cost. Investment cash flows are independent of financing choices
  • ie the coffee shop will be worth the same whether it is financed with debt or just with pure equity.

We use the assumptions of perfect capital markets thoughout this problem set (except when we’re doing taxes.)