The total market value of the common stock of the Okenfenokee Real estate compan

Question

The total market value of the common stock of the Okenfenokee Real estate company is $6 million, and the total value of its debt is $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 6%. The treasury bill rate is 4%. Assume for simplicity that Okenfenokee debt is risk-free and the company does not pay tax.
a. What is the required return on Okefenokee stock?
b. Estimate the company cost of capital.
c. What is the discount rate for an expansion of the company’s present business?
d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical manufacturers is 1.2. estimate the required return on Okefenokee’s new venture.

Explanation / Answer

A. Required return = 0.04 + (1.5 * 0.06) = 0.13 = 13% B. Debt is 4% so 0.4* .04 +.6*.13= 9.4% C. the appropriate discount rate is 9.4%. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okefenokee’s new venture. D. 0.4* .04 +.6*.112= 0.0832 = 8.32%

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