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 1.5 and that the expected risk premium on the market is 10%. The Treasury bill rate is 6%, and investors believe that Okefenokee's debt is essentially free of default risk.

a. What is the required rate of return on Okefenokee stock? (Do not round intermediate calculations. Enter your answer as a whole percent.)

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.)

d. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.7. 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.) (Do not round intermediate calculations. Enter your answer as a whole percent.)

Answer 1

a.
Using the CAPM formula we can calculate the required rate of return
Required rate of return (Ke)	Rf + Beta*(Rm-rf)
Rf is risk free rate
Rm is market return
Rm-rf represents market risk premium
Ke	0.06 + 1.50*(0.10)
Ke	0.06 + 0.15
Ke	21%
Thus, required rate of return on company's stock is 21%
b.
Calculation of WACC
WACC	Weight of equity*Cost of equity + Weight of debt*Cost of debt*(1-tax rate)
WACC	($6/($4+$6))*0.21 + ($4/($4+$6))*0.06*(1-0.21)
WACC	(0.60*0.21)+(0.40*0.06*0.79)
WACC	0.126+0.01896
WACC	14.50%
c.
The discount rate to be used for project depends on risk of project.
If risk of project is same as risk of company then discount rate used should be 14.50%
d.
Ke	0.06 + 1.70*(0.10)
Ke	0.06 + 0.17
Ke	23%