Question

he total market value of the equity of Okefenokee Condos is $3 million, and the total value of its debt is $2 million. The treasurer estimates that the beta of the stock currently is 1.1 and that the expected risk premium on the market is 10%. The Treasury bill rate is 5%, 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 30%. (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 1.3. What is the required rate of return on Okefenokee’s new venture? (Do not round intermediate calculations. Enter your answer as a whole percent.)

Answer 1

a). r_equity = Rf + beta[market risk premium]

= 5% + 1.1[10%]

= 5% + 11% = 16%

b). WACC = [We x Ke] + [Wd x Kd x (1 - t)]

= [($3,000,000/$5,000,000) x 16%] + [($2,000,000/$5,000,000) x 5% x (1 - 0.30)]

= 9.6% + 1.4% = 11%

c).  The cost of capital depends on the risk of the project being evaluated. If the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital. Here, the appropriate discount rate is 9.4%.

d). r_equity = Rf + beta[E(Rm) - Rf]

= 5% + 1.3[10%]

= 5% + 13% = 18%

WACC = [We x Ke] + [Wd x Kd x (1 - t)]

= [($3,000,000/$5,000,000) x 18%] + [($2,000,000/$5,000,000) x 5% x (1 - 0.30)]

= 10.8% + 1.4% = 12.2%