The total market value of Okefenokee Real Estate Company\'s equity is $6 million
ID: 2762550 • 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 10%. The Treasury bill rate is 4% and investors believe that Okefenokee's debt is essentially free of default risk.
a. What is the required rate of return on Okefenokee stock?
b. Estimate the WACC assuming a tax rate of 40%
c. Estime the discount rate for an expansion of the company's present business.
d. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of potical 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 an additional debt)
Explanation / Answer
Answer:
Solution a)
Market value of equity = $6 million
Market value of debt = $4 million
Total market value of firm = market value of debt + market value of equity
= $4 + $ 6 = $ 10 million
to compute the required rate of return we would use the CAPM model which is capital asset pricing model
Ke = Rf + beta ( Rm - Rf)
Rf = risk free rate
Beta = risk associated to each stock and
Rm = market return
Rm - Rf = risk premium
Hence required rate of return = .04+ 1.2(.1)
= 16%
Solution b)
To compute the WACC = Cost of equity * market value equity /Market value firm + cost of debt * market value of debt /MArket value of firm
= 16% * 6/10 + 4% * 4/10
= .16*.6 + .04*.4
WACC = 11.20 %
solution c)
The discount rate should be consider here has to be WACC hence the future cash flow should be discounted at 11.20 % because it involves both debt and equity funds.
solution d)
Required rate of return would be = 4+ 1.4(.10)
= 18% will be required rate of return
Thank you.
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