You Are Considering An Investment In Concordia Utilities
You Are Considering An Investment In Concordia Utilities And Have Some
You are considering an investment in Concordia Utilities and have some questions regarding the income generating abilities of the company. Concordia Utilities has 4 plants in four states and they all operate as separate entities. All four plants are financed by Concordia and have no holdings of their own, but operate as if they were separate companies. You have gathered some information about the company's plants as follows:
Table-1: Plant Beta Coefficient and Income Distribution
| Plant | Beta Coefficient | % of Concordia's Income |
|---|---|---|
| South Town | 0.85 | 55% |
| North Town | 0.90 | 20% |
| East Town | 1.25 | 15% |
| West Town | 1.60 | 10% |
Additionally, you have collected information about the market returns and their probabilities as shown in the following table:
Table-2: Probabilities and Market Returns
| Return | Probability |
|---|---|
| 8% | 0.15 |
| 9% | 0.20 |
| 10% | 0.50 |
| 11% | 0.10 |
| 12% | 0.05 |
Questions:
- What is the Beta coefficient for Concordia? Explain your answers.
- What is Concordia's required rate of return on any new investments? Explain your answers.
- What is the equation for the Security Market Line (SML)? Show the equation and graph the equation on a graph. Explain what the SML is telling you, and the implications for the firm.
- Suppose Concordia has the opportunity to purchase an additional plant. The cost of the new plant will be $200 million and have a beta coefficient of 1.60. If the new plant is expected to return 12%, should Concordia make the investment? Explain your answers and justify your calculations.
Paper For Above instruction
Concordia Utilities' beta coefficient represents the company's overall market risk and is derived by considering the weighted contribution of each plant's individual beta relative to its income share. To calculate the company's aggregate beta, we perform a weighted average of the plants' betas, based on their percentage contributions to total income.
Calculating the weighted beta involves multiplying each plant's beta by its income proportion and summing the results:
Weighted Beta = (0.85 0.55) + (0.90 0.20) + (1.25 0.15) + (1.60 0.10) = 0.4675 + 0.18 + 0.1875 + 0.16 = 0.995
Thus, the estimated Beta coefficient for Concordia Utilities as a whole is approximately 0.995. This beta indicates that Concordia's overall risk is slightly below the market risk level, as a beta of 1.0 signifies sensitivity equal to the market.
Next, to determine the required rate of return on new investments, we employ the Capital Asset Pricing Model (CAPM). The CAPM formula is:
Required Return = Risk-Free Rate + Beta * Market Risk Premium
Given the risk-free rate of 3% and a market risk premium of 4%, the calculation yields:
Required Return = 3% + 0.995 * 4% = 3% + 3.98% = 6.98%
Therefore, the minimum acceptable return for any new investment by Concordia Utilities should be approximately 7%. This threshold ensures investors are compensated for the systematic risk they undertake.
The Security Market Line (SML) visually depicts this relationship between systematic risk (Beta) and expected return. The general equation of the SML is:
Expected Return = Risk-Free Rate + Beta * Market Risk Premium
Graphically, the SML is a straight line intersecting the y-axis (expected return) at the risk-free rate (3%) and rising with increasing Beta, reflecting the higher expected return for higher risk.
The SML illustrates the trade-off between risk and return for securities in the market. Any security or investment lying above the line indicates it offers a return higher than the market-expected return for its beta, suggesting a potentially undervalued or attractive investment. Conversely, if it lies below, it may be overvalued or less desirable.
For Concordia, the SML implies that the company should pursue investments that ensure the expected return exceeds the rate predicted by the SML for their systematic risk level, approximately 7%. An investment offering an expected return below this threshold would be considered insufficient given their risk profile.
Considering the opportunity to acquire a new plant costing $200 million with a beta of 1.60, the expected return on this new project is 12%. To evaluate whether Concordia should proceed, compare this expected return with the required return based on the project's beta:
Required Return for the new plant = 3% + 1.60 * 4% = 3% + 6.4% = 9.4%
Since the expected return of 12% exceeds the required rate of approximately 9.4%, investing in this new plant appears financially favorable as it promises return above the minimum compensation for its risk. This indicates that, from a CAPM perspective, the project adds value to Concordia and should be considered a viable investment.
Overall, by integrating industry-specific data, market assumptions, and systematic risk assessments, Concordia Utilities can refine its investment decisions to maximize stakeholder value while managing risk exposure effectively.
References
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