Question

The total market value of the common stock of the Okefenokee Real Estate Company is $13 million, and the total value of its debt is $8.2 million. The treasurer estimates that the beta of the stock is currently 1.7 and that the expected risk premium on the market is 8%. The Treasury bill rate is 3%. Assume for simplicity that Okefenokee debt is risk-free and the company does not pay tax. a. What is the required return on Okefenokee stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) b. Estimate the company cost of capital. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) c. What is 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 spectacles. The beta of unleveraged optical manufacturers is 1.20. Estimate the required return on Okefenokee's new venture. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Required return Cost of capital Discount rate d. Required return

Answer 1

a). Required return = rF + [Beta * Expected Market Risk Premium]

= 3% + [1.7 * 8%] = 3% + 13.6% = 16.6%

b). Cost of Capital = [wD * rD] + [wE * rE]

= [{8.2/(8.2 + 13)} * 3%] + [{13/(8.2 + 13)} * 16.6%]

= 1.16% + 10.18% = 11.34%

c). Appropriate Discount Rate is 11.34% as it depends on the risk of the project being evaluated, which is same as the present business.

d). Required return = rF + [Beta * Expected Market Risk Premium]

= 3% + [1.2 * 8%] = 3% + 9.6% = 12.6%

Cost of Capital = [wD * rD] + [wE * rE]

= [{8.2/(8.2 + 13)} * 3%] + [{13/(8.2 + 13)} * 12.6%]

= 1.16% + 7.73% = 8.89%