Question

The total market value of Okefenokee Real Estate Company’s equity 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 essentialy 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.)

Required rate of return

%

b.	Estimate the WACC assuming a tax rate of 30%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

WACC

%

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.)

Discount rate

%

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.)

Required rate of return

%

Answer 1

1. Using CAPM,

Required return of stock               = R_f + Beta (R_m – R_f)

                                                                = 0.05 + 1.1( 0.1)

                                                                = 0.05 + 0.11

                                                                = 16 %

2. WACC    = Weight of Stock * Return of Stock + Weight of debt * return of debt

= 3/5 * 0.16 + 2/5 * {0.05(1-0.3)}

= 0.096 + 0.014

= 0.11 or 11%

3. The cost of capital is evaluated on the basis of the project. If risk of project is same as other assets of company, the appropriate return is the cost of capital.

Therefore, discount rate for expansion = 11%

4. Using CAPM approach again

R_equity        = R_f + Beta (R_m – R_f)

                        = 0.05 + 1.3 * 0.1

                = 0.18 or 18%

Now,

Required rate of return on new venture

                                                = Weight of Stock * Return of Stock + Weight of debt * return of debt

                                                                = 3/5 * 0.18 + 2/5 * {0.05(1-0.3)}

                                                                = 0.108 + 0.014

                                                                = 12.2 %

= rounded off to 12 %

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