The total market value of Okefenokee Real Estate Company\'s equity is $3 million

Question

The total market value of Okefenokee Real Estate Company's equity is $3 million, and the total value of its debt is $2 million. The treasurer estimates that the beta of the stock currently is 1.1 and that the expected risk premium on the market is 10%. The Treasury bill rate is 5%. a. What is the required rate of return on Okefenokee stock? Required rate of return 10.5 % 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 .66 c. Estimate the weighted-average cost of capital assuming a tax rate of 30%. (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 1.3. 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

Required rate of return on Okefenokee stock by CAPM model = Rf + Beta ( Risk Premium)

= 5% + 1.1 ( 10%)

= 16%

If Required rate of return = 10.5% then New Beta ==> 10.5%=5%+New Beta (10%)==> new Beta=0.55

Beta of Companies Port Folio = We(Beta of Equity ) + Wd ( Beta of Debt)

=3/5(0.55) + 2/5 (0)

= 0.33

WACC ( weighted Average cost of Capital) = We(Cost of Equity ) + Wd ( cost of Debt)(1-Tax)

= 3/5 (16%) + 2/5 (5%) ( 1-0.3)

= 11%

Discount rae for expansion can be taken at WACC provided if expansion takes place at the same proportion of Debt & Equity = 11%

The beta of optical manufacturers with no debt outstanding is 1.3

==> 1.3= 3/5(Beta of Eqity) + 2/5 ( Beta of Debt )

==>1.3= 3/5(Beta of Eqity) + 2/5 ( 0 )

==> Beta of Equity = 2.17

Required rate of Return = 5%+ 2.17 ( 10%)=26.7%

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