The total market value of Okefenokee Real Estate Company\'s equity is $6 million
ID: 2755186 • Letter: T
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 1.5 and that the expected risk premium on the market is 6%. The Treasury bill rate is 5%
a. What is the required rate of return on Okefenokee stock?
b.What is the beta of the company’s existing portfolio of assets? The debt is perceived to be virtually risk-free. (Round your answer to 2 decimal places.)
c. Estimate the weighted-average cost of capital assuming a tax rate of 35%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
d. Estimate the discount rate for an expansion of the company’s present business. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 2.5. 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.)
.a. What is the required rate of return on Okefenokee stock?
b.What is the beta of the company’s existing portfolio of assets? The debt is perceived to be virtually risk-free. (Round your answer to 2 decimal places.)
c. Estimate the weighted-average cost of capital assuming a tax rate of 35%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
d. Estimate the discount rate for an expansion of the company’s present business. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 2.5. 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.)
Explanation / Answer
a) Required Rate of return (Re) using CAPM = Rf+beta (Rm-Rf)
= 5% +(1.5) (6%)
= 14%
b) Beta of Company portfolio = We(beta of equity) + Wd ( beta of Debt)
= (6/10)*(1.5) +( 4/10) * (0)
= 0.9
c) Assume cost of debt = 5%
Weighted Avereage cost of Capital = We(Ke) + Wd ( Kd)
=(6/10)*14% + (4/10) * 5%*(1-.35)
=23.4%
d) if the Expansion is at the same proportion of Debt & Equity then Weighted average cost of capital is the Discount rate = 23.4%
e) Given Beta of new venture =2.5
then new Ke = 5% + 2.5(6) =20%
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