Question

The total market value of Okefenokee Real Estate Company’s equity is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock currently is 1.0 and that the expected risk premium on the market is 12%. The Treasury bill rate is 4%, 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 1.5. 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

a.) Required rate of return on stock: R_e  = R_f + B (R_m - R_f ) (Using CAPM equation)

Where R_f = Risk Free Rate ; R_m - R_f = Expected risk premium ; Beta = B = 1.0

R_e = 4% + 1.0*(12%) = 16% (Answer Part a)

b.) WACC: D/V * (1 - T) * R_d + E/V * R_e

D = Value of Debt ($4 million) ; E = Value of Equity ($6 million) ; V = Value of company ($4 + $6 = $10 million)

WACC = 4/10*(1 - 0.30)*0.04 + 6/10*0.16 = 0.0112 + 0.096 = 0.1072 = 10.72% (Answer Part b)

c.) Discount rate for an expansion of the company's present business will be same as WACC of the company if the risk profile of project undertaken for company's expansion is similar to risk profile of company's business as a whole. Therefore discount rate for an expansion of company's present business is 10.72% (Answer Part c)

d.) Cost of equity for new venture: R_e = R_f + B*(R_m - R_f) = 4% + 1.5*12% = 22%

R_{new venture} = D/V * (1 - T) * R_d + E/V * R_e

D = Value of Debt ($4 million) ; E = Value of Equity ($6 million) ; V = Value of company ($4 + $6 = $10 million)

R_{new venture} = 4/10*(1 - 0.30)*0.04 + 6/10*0.22 = 0.0112 + 0.132 = 0.1432 = 14.32% = 14% (Approx) (Answer part d : Required rate of return on new venture)