Question

The total market value of the equity of Okefenokee Condos is $3 million, and the total value of its debt is $2 million. The treasurer estimates that the beta of the stock currently is 1.1 and that the expected risk premium on the market is 10%. The Treasury bill rate is 5%, and investors believe that Okefenokee's debt is essentially free of default risk.

a. What is the required rate of return on Okefenokee stock? (Do not round intermediate calculations. Enter your answer as a whole percent.)

b. Estimate the WACC assuming a tax rate of 21%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. Estimate the discount rate for an expansion of the company’s present business. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

d. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.3. What is the required rate of return on Okefenokee’s new venture? (You should assume that the risky project will not enable the firm to issue any additional debt.) (Do not round intermediate calculations. Enter your answer as a whole percent.)

Answer 1

a. Required Rate of Return = Risk-free Rate + Beta*(Risk Premium)

Required Rate of Return = 5% + 1.1*(10%)

Required Rate of Return = 16%

b. WACC = Weight of Debt*Cost of Debt*(1-corporate tax rate) + Weight of Equity*Cost of Equity

Weight of Debt = 2mn/5mn

Weight of Debt = 0.4

Weight of Equity = 0.6

Cost of Equity = 16%

Cost of Debt = 5%

WACC = 0.4*5%*(1-.21) + 0.6*16%

WACC = 1.58% + 9.6%

WACC = 11.18%

c. The discount rate for an expansion of the company’s present business is the Weighted Average cost of Capital, which is 11.18%.

d. The required rate of return on Okefenokee’s new venture

Required Rate of Return = Risk-free Rate + Beta*(Risk Premium)

Required Rate of Return = 5% + 1.3(10%)

Required Rate of Return = 5% + 13%

Required Rate of Return = 18%