PART 1
Company Allocation Ticker symbol | Company | | GICS Sector | GICS Sub Industry | Address of Headquarters | | BEN | Franklin Resources | | Financials | Diversified Financial Services | San Mateo, California | | FCX | Freeport-McMoran Cp & Gld | | Materials | Diversified Metals & Mining | Phoenix, Arizona | |
The cost of capital of the aforementioned companies will be discussed in the following questions. The companies will be referred to by their Ticker Symbols henceforth.

Question 1
BEN
The book value of the company’s liabilities and equity can be deduced from a number of online sources. The US Securities and Exchange Commission (2013) provided the company filings data whereby BEN’s Form 10q, dated 29/07/2013, showed the following (included on page 2 of this report). The book value of long-term debt is $1,252.1 million, and the book value of equity is $10,402.3 million.
The schedule of outstanding debt shows that this figure includes $54.5 million of FHLB advances and $1197.6 million of Senior Notes at various effective interest rates. The notes on Stockholders Equity and Non- Redeemable Non-Controlling Interests reveal that Franklin Resources Inc Stockholders Equity totals $9779.8 million whilst the Non- Redeemable Non-Controlling Interests (previously referred to as minority interests) totals $622.5 million.

FCX
The book value of the company’s liabilities and equity can be deduced from a number of online sources. The US Securities and Exchange Commission (2013) provided the company filings data whereby FCX’s Form 10q, dated 09/08/2013, showed the following (included on page 2 of this report). The book value of long-term debt is $21,142 million, and the book value of equity is $23,867 million.
The schedule of outstanding debt shows that this figure is made up of around $10,500 million of acquisition-related debt and around $7,100 million of debt assumed in the acquisitions of PXP and MMR (US Securities and Exchange Commission (2013)). As of June 30, 2013, debt included $708 million of fair value adjustments. All of FCX's debt is unsecured. The consolidated balance sheet also reveals that FCX Equity totals $19,878 million whilst the Non- Redeemable Non-Controlling Interests (previously referred to as minority interests) totals $3,989 million.
Question 2
BEN
What is the most recent stock price listed for those companies?
BEN – $51.67 (Yahoo, 2013)
FCX -$33.78 (Yahoo, 2013)
What is the market value of equity, or market capitalization?
BEN – $32.82 billion
FCX - $35.06 billion
FCX
What is the beta for each company?
BEN – 1.59
FCX – 2.29
How many shares of stock do those companies have outstanding?
BEN – 635.2 million shares outstanding
FCX – 1.04 billion shares outstanding
What is the yield on 3-month Treasury bills?
Yield: 0.00
Using a 7 percent market risk premium, what is the cost of equity for each company using the CAPM?
BEN: 0% + 1.59(7%) = 11.13%
FCX: 0.00 + 2.29 (7%) = 16.03%

Is beta dead? Explain.

The CAPM beta is arguably the most important advance in financial economics. It allows the investor to calculate the expected return on an asset with reference to the stock’s beta and had remained relatively untested until 20 years ago (Ross et al, 2013). The CAPM presumes that there is a ‘positive linear dependence of expected stock returns and CAPM betas (that capture the sensitivity of asset return to market return) and that CAPM beta is sufficient for explaining expected stock returns’(Novak, 2007).
Despite its popularity, past studies have documented weak association between the CAPM and realized stock returns, which led academic researchers and the press to declare that the beta was ‘dead’(Novak, 2007). The points made by the papers on the subject argue that the relationship between average return and beta is weak over the period 1941 to 1990 and virtually non-existent from 1963 to 1990. They subsequently contend that the average return on a security is negatively related to the firm’s P/E ratio and the firms M/B ratio (Ross et al, 2013). Criticisms too follow these papers with concerns raised around the length of time used to test the CAPM, hindsight bias and data mining (Ross et al, 2013).

Question 3
Unfortunately, no portfolio with a required rate of return of 8% can be created from BEN, stock 1, and FCX, stock 2, as the required rate of return of each stock is greater than the desired portfolio rate of return of 8%. At best, if 100% of the $20,000 was invested into Stock 1, the required rate of return would be 11.13% which is closest to the desired portfolio return. At worst if 100% of the $20,000 was invested into Stock 2, the required rate of return would be 16.03% which is furthest away from the desired portfolio return.
If the investor could be swayed into investing in Treasury bonds then a portfolio with a required rate of return on 8% can be created with: $7200 invested into BEN, $500 invested into FCX, $7800 invested into Treasury Bonds.

Question 4 Financial Industry Competitors | Beta | Barclays PLC | 2.7 | State Street Corporation | 1.55 | T. Rowe Price Group, Inc. | 1.67 | Janus Capital Group Inc | 2.69 | AllianceBernstein Holding LP | 1.69 | Franklin Resources Inc | 1.59 | INDUSTRY AVERAGE | 1.98 |

Cost of Equity for Financial Industry: 0% + 1.98 (7%) = 13.86% Materials Industry Competitors | Beta | Hindustan Zinc Ltd | 0.89 | Jiangxi Copper Co Ltd | 1.93 | Rio Tinto Limited | 1.53 | Rio Tinto plc | 1.53 | Xstrata PLC | N/A | Southern Copper Corp | 1.50 | Freeport-McMoran Cp & Gld | 1.62 | INDUSTRY AVERAGE | 1.5 |

Cost of Equity for Materials Industry: 0% + 1.5 (7%) = 10.5%

Does it matter if you use the beta for those two companies or the beta for the industry in this case? Explain each company separately.
BEN has a beta of 1.59 whereas BEN’s competitors have an average beta of 1.98. According to Reuters (2013) the financials industry has a beta of 1.51.
FCX has a beta of 2.29 whereas FCX’s competitors have an average beta of 1.5. According to Reuters (2013) the materials industry has a beta of 1.13.
It is preferential to use the beta of the companies themselves rather than the beta of their competitors or the beta of the industry they are in when valuing the cost of equity. The industry average beta may be useful when valuing projects where the project’s beta differs from that of the firm.

Question 5 BEN | | Book Value (thousands) | % of total | Quoted price | Market Value (millions) | % of total | Yield to maturity | Book values | Market values | Bond 1 | 300 | 0.26 | 93.7 | 28.11 | 0.24 | 3.632 | 0.94432% | 0.87168% | Bond 2 | 250 | 0.22 | 98.076 | 24.519 | 0.21 | 1.882 | 0.41404% | 0.39522% | Bond 3 | 350 | 0.30 | 109.041 | 38.16435 | 0.33 | 3.110 | 0.933% | 1.0263% | Bond 4 | 250 | 0.22 | 103.724 | 25.931 | 0.22 | 0.817 | 0.17974% | 0.17974% | Bond 5 | N/A | | 99.250 | N/A | | N/A | | | Total | 1150 | 1.00 | | 116.72435 | | | 2.4711% | 2.47294% |

FCX | | Book Value (Thousands) | % of total | Quoted price | Market Value (millions) | % of total | Yield to maturity | Book values | Market values | Bond 1 | 1500 | 0.11 | 104.150 | 156.225 | 0.19 | 5.929% | 0.6522% | 1.13% | Bond 2 | 500 | 0.04 | 100.342 | 50.171 | 0.06 | 1.143% | 0.0457% | 0.07% | Bond 3 | 2000 | 0.15 | 99.592 | 199.184 | 0.24 | 2.275% | 0.3413% | 0.55% | Bond 4 | 1000 | 0.07 | 91.781 | 91.781 | 0.11 | 4.748% | 0.3324% | 0.52% | Bond 5 | 2000 | 0.15 | N/A | | | N/A | | | Bond 6 | 1500 | 0.11 | 97.114 | 145.671 | 0.17 | N/A | | | Bond 7 | 2000 | 0.15 | N/A | | | N/A | | | Bond 8 | 1500 | 0.11 | 95.494 | 143.241 | 0.17 | 3.433% | 0.3776% | 0.5836% | Bond 9 | N/A | | N/A | | | N/A | | | Bond 10 | 1000 | 0.07 | N/A | | | N/A | | | Bond 11 | N/A | | 93.818 | | | N/A | | | Bond 12 | N/A | | 91.230 | | | N/A | | | Bond 13 | N/A | | 87.162 | | | N/A | | | Bond 14 | N/A | | 97.010 | | | N/A | | | Bond 15 | 150 | 0.01 | 99.500 | 14.925 | 0.02 | 6.168% | 0.0617% | 0.1234% | Bond 16 | 150 | 0.01 | 113.346 | 17.0019 | 0.02 | 5.730% | 0.0573% | 0.1146% | Bond 17 | 150 | 0.01 | 129.529 | 19.42935 | 0.02 | 6.635% | 0.0664% | 0.1327% | Total | 13450 | 1.00 | | 837.62925 | 1.00 | | 1.9346% | 3.2243% |

What is the weighted average cost of debt for each of the two companies using the book value weights and the market value weights?
BEN
Book Value Weighted Average Cost of Debt = 2.47%
Market Value Weighted Average Cost of Debt = 2.47%
FCX
Book Value Weighted Average Cost of Debt = 1.93%
Market Value Weighted Average Cost of Debt = 3.22%

Does it make a difference in this case if you use book value weights or market value weights?
The figures above show that BEN has a similar book value to the market value of their weighted average cost of debt whereas FCX shows a considerable disparity between the two figures. As a rule, market value weights for each financing element are preferred over book value weights, as market values reflect the ‘true economic claim of each type of financing outstanding whereas book values may not’ (Macabus, 2013). They are closer to the actual proceeds that would be received upon sale (Ross et al, 2013).

Question 6 BEN – MARKET VALUE | Financing Component | Market Values | Weight | Cost of Capital (after Corporate Tax) | Weighted Cost of Capital | Debt | 116,724,350 | 0.0035 | 2.47 x (1-0.3) = 1.729% | 0.006% | Equity | 32,820,000,000 | 0.9965 | 11.13% | 11.09% | Total | 32,936,724,350 | 1.00 | | 11.10% |

BEN – BOOK VALUE | Financing Component | Book Values | Weight | Cost of Capital (after Corporate Tax) | Weighted Cost of Capital | Debt | 1,252,100,000 | 0.12 | 2.47 x (1-0.3) = 1.729% | 0.21% | Equity | 10,402,300,000 | 0.88 | 11.13 | 9.79% | Total | 11,654,400,000 | 1.00 | | 10% |

FCX – MARKET VALUE | Financing Component | Market Values | Weight | Cost of Capital(after Corporate Tax) | Weighted Cost of Capital | Debt | 837,629,250 | 0.023 | 3.22 x (1-0.3) =2.254% | 0.05% | Equity | 35,060,000,000 | 0.977 | 16.03% | 15.66% | Total | 35,987,629,250 | 1.00 | | 15.71% |

FCX – BOOK VALUE | Financing Component | Book Values | Weight | Cost of Capital (after Corporate Tax) | Weighted Cost of Capital | Debt | 21,142,000,000 | 0.47 | 1.93 x (1-0.3) = 1.35% | 0.63% | Equity | 23,867,000,000 | 0.53 | 16.03% | 8.5% | Total | 45,009,000,000 | 1.00 | | 9.13% |

Which cost of capital number is more relevant? Identify the pros and cons for book value weights and market value weights under different situations.
The Market Value WACC is more relevant than Book Value WACC for the following reasons: BOOK VALUE WEIGHTS | PROS | CONS | * Simplicity of use * Figures are easily derived from financial statements * Firms in practice set their target capital structure in terms of book values rather than market values | * Book value weights are based on arbitrary accounting policies and as such do not accurately reflect economic values. * Book value of equity is against the principle of shareholders' wealth maximization. Projects may be incorrectly accepted/rejected based upon these usually higher figures. * Book value weights may lead to an underestimated WACC. The higher a firm’s M/B ratio, the more the WACC is underestimated. | MARKET VALUE WEIGHTS | PROS | CONS | * Accurately reflect economic values * Provide figures closer to actual proceeds that would be received from a sale | * Difficult to derive * Target weights are preferred over market weights if available |

Book value weights should only be used where market value and target weights are unreliable or unavailable.

Part 2: Leasing 1. What is the NPV of the lease for FIN322? | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Purchase SavingsLease Payments | 250-62 | -62 | -62 | -62 | -62 | -62 | Net Cash Flows | 188 | -62 | -62 | -62 | -62 | -62 |

NPV = 188 – 62 x PVIA (.08, 5) = -59.55

2. What is the NPV for CoLease?

| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Purchase PriceDepr Tax ShieldA-T lease income | -25040.3 | 17.540.3 | 17.540.3 | 17.540.3 | 17.540.3 | 17.540.3 | Net Cash Flows | -209.7 | 57.8 | 57.8 | 57.8 | 57.8 | 57.8 |
Depr Tax shield = .35 x 250/5 = 17.5
After Tax Lease Income = 62(1-0.35) = 40.3
NPV = -209.7 + 57.8 x PVIA (0.052, 5) = $39.16 3. What is the overall gain from leasing?
The overall gain to leasing is negative in this case: $39.16 - $59.55 = -$20.39. The lessor’s tax benefit from depreciation tax shield is outweighed by its tax liability on the lease payment it receives (Gervais, 2011).

4. How does the position of an equipment lessor differ from the position of a secured lender when a firm falls into bankruptcy? Assume that the secured loan would have the leased equipment as collateral. Which is better protected, the lease or the loan? Does your answer depend on the value of the leased equipment if it were sold or re-leased?

The position of an equipment lessor differs from the position of a secured lender when a firm falls into bankruptcy, in that, lenders get first claim on lease payments and on the asset but they have no recourse to the equity investment made by the lessor. Thus the lender’s must depend solely on the lessee’s credit and the equipment as collateral (Brealey et al, 2011). In most financial distress situations including bankruptcy, lessors are found to fare better than lenders, so the lease is better protected than the loan. Lessors may be more willing to deal with firms in poor financial condition than lenders may be for this reason. The answer is not dependant upon the value of the leased equipment.

REFERENCES

Brealey R, Myers C, Allen F (2011) Principles of Corporate Finance, 10th Edition, McGraw-Hill, USA
Finra (2013) Bonds, FINRA, viewed 07/10/2013, http://finra-markets.morningstar.com/BondCenter/Default.jsp
Gervais, S (2011) Problem Set 6, Fuqua School of Business, Duke University, USA, viewed 07/10/2013, https://faculty.fuqua.duke.edu/~sgervais/TeachingNew/TeachingMBA/Download/PS06.Main.pdf
HAP (2012) Lease Financing and Business Valuation, Health and Administrative Press, viewed 07/10/2013, http://www.ache.org/PUBS/HAP_Companion/GapenskiFHF2/FHFCH15E2_clean.pdf
Ross, S, Westerfield, R, Jaffe, J (2013) Corporate Finance, 10th Edition, McGraw-Hill, USA, 11A-1
Novak, J, (2007) ‘Is CAPM Beta Dead or Alive?’, Uppsala University, Sweden, ies.fsv.cuni.cz/default/file/download/id/7700

Reuters (2013) Markets, Reuters, viewed 07/10/2013, (Reuters, 2013)

US Securities and Exchange Commission (2013) FRANKLIN RESOURCES INC (Filer) CIK: 0000038777, US Securities and Exchange Commission , viewed 06/10/2013, http://www.sec.gov/cgi-bin/viewer?action=view&cik=38777&accession_number=0000038777-12-000243&xbrl_type=v#
US Securities and Exchange Commission (2013) FREEPORT MCMORAN COPPER & GOLD INC (Filer) CIK: 0000831259, US Securities and Exchange Commission, viewed 06/10/2013, http://www.sec.gov/cgi-bin/viewer?action=view&cik=831259&accession_number=0000831259-13-000014&xbrl_type=v#
Yahoo (2013), Freeport-McMoRan Copper & Gold Inc. (FCX), Yahoo Finance, viewed 06/10/2013, http://finance.yahoo.com/q?s=fcx&ql=1
Yahoo (2013), Franklin Resources Inc. (BEN), Yahoo Finance, viewed 06/10/2013, http://finance.yahoo.com/q?s=ben&ql=1
Macabus (2013), WACC, Macabus, viewed 07/10/2013, http://www.macabacus.com/valuation/dcf/wacc