4. The total market value of the common stock of the Okenfenokee Real Estate Com
ID: 2635127 • Letter: 4
Question
4. The total market value of the common stock of the Okenfenokee Real Estate Company is $6 million, and the total value of its debt of $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 10%. The Treasury bill rate is 8%. a. What is the required return on Okenfenokee stock? b. What is the beta of the company's existing portfolio of assets? c. Estimate the company's cost of capital d. Estimate the discount rate for an expansion of the company's present business.Explanation / Answer
a) Market value of common stock is $6 million and the market value of debt is $4 million. Beta of the stock is 1.5, expected risk premium is 10% and the T-Bill rate is 8%.
Total market value is the sum of market value of debt and market value of equity.
Total market value = $6,000,000 + $4,000,000 = $10,000,000
Weight of common stock = $6,000,000 / $10,000,000 = 0.6
Weight of debt = $4,000,000 / $10,000,000 = 0.4
Required return = Risk free rate + Beta (Market risk premium) = 8% + 1.5 (10%) = 8% + 0.15 = 0.23 or 23.00%
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b) Compute the beta of the existing portfolio of assets:
Portfolio beta = (60 / 100) (Beta of common stock) + (40 / 100) X (Beta of debt)
= 0.6 X 1.5 + 0 {Since the beta of debt is zero) = 0.9
Therefore, the beta of the portfolio is 0.9
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c) Cost of capital is the WACC:
WACC= (Weight equity X Cost of equity) + (Weight of debt X Cost of debt)
= (0.6 X 0.23 ) + (0.4 X 0)
= 0.138
Therfore, the WACC to be used is 0.138 or 13.8%
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4) If the company is considering a project which is just an expansion of the company's present business, then the discount rate to be used is
Required return = 8% + 0.9 (0.10) = 0.08 + 0.09 = 0.17 or 17.00%
Therefore, at this discount rate, the company can expand the business.
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