The total market value of Okefenokee Real Estate Company\'s equity is $6 million
ID: 2798512 • 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%.
What is the required rate of return on Okefenokee stock?
Required rate of return %
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.)
Weighted-average beta
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.)
WACC %
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.)
%
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.)
What is the required rate of return on Okefenokee stock?
Explanation / Answer
Risk free = treasury bill = 5%
Beta = 1.5
Rm-rf = 6%
The required rate of return on Okefenokee stock = cost of equity = Ke
Ke = rf+beta(rm-rf)
=rf+beta(market risk premium)
=5%+1.5*(6%)
=14%
Equity = 6million and debt = 4million
Thus weight of equity = We = 6/6+4 = 0.6
weight of debt = Wd = 4/6+4 = 0.4
Cost of equity = Ke = 14%
Cost of debt = 5% as its risk free and tax is 35%
hence after tax cost of debt = Kd = debt*(1-tax)
=5%*(1-0.35)
=3.25%
WACC = We*Ke + Wd*Kd
=0.6*0.14 + 0.4*0.0325
=0.084 + 0.013
=0.097
=9.7%
If the company wants to expand the discount rate for an expansion of the company’s present business = WACC = 9.7%
The required rate of return on Okefenokee’s new venture with company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 2.5.
Beta = 2.5
The required rate of return on Okefenokee stock = cost of equity = Ke
Ke = rf+beta(rm-rf)
=rf+beta(market risk premium)
=5%+2.5*(6%)
=20%
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