Question

The total market value of the equity of Okefenokee Condos is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock currently is 1.0 and that the expected risk premium on the market is 12%. The Treasury bill rate is 4%, and investors believe that Okefenokee's debt is essentially free of default risk.

b. Estimate the WACC assuming a tax rate of 21%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. Estimate the discount rate for an expansion of the company’s present business. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

b). Total Market Value = Market Value of Debt + Market Value of Equity

= $4 million + $6 million = $10 million

According to the CAPM,

kE = rF + [Beta * Market Risk Premium] = 4% + [1 * 12%] = 4% + 12% = 16%

kD = Risk-free Rate = 4%

WACC = [wD * kD * (1 - t)] + [wE * kE]

= [(4/10) * 4% * (1 - 0.21)] + [(6/10) * 16%]

= 1.264% + 9.60% = 10.864%, or 10.86%

c). Discount Rate = WACC of the company = 10.86%