The total market value of Okefenokee Real Estate Company\'s equity is $12 millio

Question

The total market value of Okefenokee Real Estate Company's equity is $12 million, and the total value of its debt is $8 million. The treasurer estimates that the beta of the stock currently is 1.4 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 ______%

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 1.6. 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

a)

As per CAPM

Required Rate of Return = Risk free rate + market risk premium*beta

Required Rate of Return = 5 + 10*1.4

Required Rate of Return = 19%

b)

Beta of the company’s existing portfolio of assets = Weight of Equity * Beta of Equity + Weight of debt*beta of debt

Beta of the company’s existing portfolio of assets = 12/(12+8) * 1.4 + 8/(8+12) *0

Beta of the company’s existing portfolio of assets = 0.84

c)

weighted-average cost of capital = Weight of Equity * cost of Equity + Weight of debt*cost of debt*(1-tax rate)

weighted-average cost of capital =  12/(12+8) * 19 + 8/(8+12) *5*(1-35%)

weighted-average cost of capital = 12.70%

d)

Discount rate = WACC

Discount rate = 12.70%

e)

As per CAPM

Required Rate of Return = Risk free rate + market risk premium*beta

Required Rate of Return = 5 + 10*1.6

Required Rate of Return = 21%

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