Question

The total market value of the common stock of the Okefenokee Real Estate Company is $9.5 million, and the total value of its debt is $6.1 million. The treasurer estimates that the beta of the stock is currently 1.6 and that the expected risk premium on the market is 9%. The Treasury bill rate is 5%. Assume for simplicity that Okefenokee debt is risk-free and the company does not pay tax.

1. What is the required return on Okefenokee stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
2. Estimate the company cost of capital. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
3. What is 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.)
4. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical manufacturers is 1.20. Estimate the required return on Okefenokee's new venture. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.

A. Required Return:_____%

B. Cost of Capital:____%

C. Discount Rate:_____%

D. Required Return:______%

Answer 1

a

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 5 + 1.6 * (9)

Expected return% = 19.4

b

D/E = 6.1/9.5=0.6421

D/A = D/(E+D)

D/A = 0.6421/(1+0.6421)

=0.391

Weight of equity = 1-D/A

Weight of equity = 1-0.391

W(E)=0.609

Weight of debt = D/A

Weight of debt = 0.391

W(D)=0.391

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5*(1-0)

= 5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5*0.391+19.4*0.609

WACC =13.77%

c

Discount rate = WACC = 13.77%

d

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 1.6*(1+((1-0)*(0.6421)))

levered beta = 2.63

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 5 + 2.63 * (9)

Expected return% = 28.67

D/A = D/(E+D)

D/A = 0.6421/(1+0.6421)

=0.391

Weight of equity = 1-D/A

Weight of equity = 1-0.391

W(E)=0.609

Weight of debt = D/A

Weight of debt = 0.391

W(D)=0.391

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5*(1-0)

= 5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5*0.391+28.67*0.609

WACC =19.42%