The total market value of Okefenokee Real Estate Company\'s equity is $14 millio

Question

The total market value of Okefenokee Real Estate Company's equity is $14 million, and the total value of its debt is $6 million. The treasurer estimates that the beta of the stock currently is 1.2 and that the expected risk premium on the market is 10%. The Treasury bill rate is 5%.

What is the required rate of return on Okefenokee stock?

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.)

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.)

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 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.)

The total market value of Okefenokee Real Estate Company's equity is $14 million, and the total value of its debt is $6 million. The treasurer estimates that the beta of the stock currently is 1.2 and that the expected risk premium on the market is 10%. The Treasury bill rate is 5%.

Explanation / Answer

Part A)

The required return can be calculated with the use of following formula:

Required Rate of Return = Risk Free Rate + Beta*(Market Risk Premium)

________

Using the values provided in the question, we get,

Required Rate of Return = 5 + 1.2*(10) = 17%

________

Part B)

The beta of the portfolio of existing assets can be calculated with the use of following formula:

Weighted Average Beta = Beta of Debt*(Market Value of Debt)/(Total Market Value) + Beta of Equity*(Market Value of Equity)/(Total Market Value)

Where Total Market Value = Market Value of Debt + Market Value of Equity

________

Since, the debt is risk free, the beta of debt will be 0.

Using the values provided in the question, we get,

Weighted Average Beta = 0*(6)/(6+14) + 1.2*(14)/(6+14) = .84

________

Part C)

The WACC can be calculated with the use of following formula:

WACC = After-Tax Cost of Debt*(Market Value of Debt)/(Total Market Value) + Cost of Equity*(Market Value of Equity)/(Total Market Value)

Where Total Market Value = Market Value of Debt + Market Value of Equity

________

Here, After-Tax Cost of Debt will continue to be 5% as treasury bills are exempt from tax.

Using the cost of equity calculated in Part A and values provided in the question, we get,

WACC = 5%*(6)/(6+14) + 17%*(14)/(6+14) = 13.40%

________

Part D)

The discount rate for an expansion of the company’s present business would be same as the cost of capital estimated in Part C which is 13.40%. This is true in case of a project that has risk similar to the existing assets of the company.

________

Part E)

With the revised beta, the cost of equity will be calculated as follows:

Revised Cost of Equity = 5 + 1.4*10 = 19%

Using this value of cost of equitry in the formula for WACC, we will get the required rate of return as follows:

Required Rate of Return (New Venture) = 5%*(6)/(6+14) + 19%*(14)/(6+14) = 14.80%

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