The total market value of Okefenokee Real Estate Company\'s equity is $6 million
ID: 2806489 • 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 1.2 and that the expected risk premium on the market is 5%. The Treasury bill rate is 3%. a. What is the required rate of return on Okefenokee stock? Required rate of return % 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.) Weighted-average beta 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.) WACC % 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.) Discount rate % e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.4. 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.) Required rate of return % rev: 12_07_2012
Explanation / Answer
a)required rate of return on Okefenokee stock=Rf+[beta*market premium]
= 3+[1.2*5]
= 3 + 6
= 9 %
b)Total market value = 6+4=10
beta of the company’s existing portfolio of assets =[beta of debt*Weight of debt]+[beta of equity * We]
= [0*4/10]+[1.2*6/10]
=0 + .72
= .72
c)weighted average cost of capital =[after tax Cost of debt *Wd]+[cost of equity *We]
=[3(1-.35)* 4/10]+[9*6/10]
= [3*.65*4/10]+5.4
= .78+5.4
= 6.18%
d)discount rate for an expansion of the company’s present business equals to weighted average cost of capital = 6.18%
e)cost of equity = 3+[1.4*5]
= 3 + 7
= 10%
required rate of return on Okefenokee’s new venture =[after tax Cost of debt *Wd]+[cost of equity *We]
=[3(1-.35)* 4/10]+[10*6/10]
= [3*.65*4/10]+6
= .78+6
=6.78%
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