The total market value of Okefenokee Real Estate Company\'s equity is $4 million

Question

The total market value of Okefenokee Real Estate Company's equity is $4 million, and the total value of its debt is $1 million. The treasurer estimates that the beta of the stock currently is 1.0 and that the expected risk premium on the market is 11%. 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 20%. (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 1.0. 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 %

Explanation / Answer

Part A

Beta= 1; Risk Free Rate(Rf)= 3%; Risk Premium(Rm-Rf)= 11%

So Cost of Capital,K= Rf+beta(Risk Premium) = 3+1(11)= 14%

Part B

Debt is perceived to be risk free so Kd(Cost of Debt)= 3%

Debt,D= $1 Million; Equity,E= $4 Million; Total Portfolio Value,V=$5 million

Tax Rate, T=20%

Beta (Unlevered in the above case), Bu= 1

Beta(Levered)= Bl=Bu(1+(1-T)D/E)= 1(1+0.8/4)= 1.2

So Beta(Levered)= 1.2

Part C

Ke(cost of equity)= Rf + Betal (Risk Premium) = 3+1.2(11)= 16.2%

Kd(Cost of Debt)= 3%

WACC= (E/V)(Ke)+(D/V)*Kd*(1-T)= 13.44%

Part D

Discount rate for Expansion if expansion is done using same Capital Structure will be WACC i.e. 13.44%

Part E

If no additional debt can be allowed in diversification so let us assume that is diversifies by issuing additional Equity with Beta = 1 of amount $5 million.

So new rate of return will be Ke2= 3+1(11)= 14%

Net WACC= (E1/V)(Ke)+ (E2/V)(Ke2) +(D/V)*Kd*(1-T)

where E1=4; E2=5; D=1; V=10

So WACC= 13.72%

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