Question

he total market value of the common stock of the Okefenokee Real Estate Company is $11.5 million, and the total value of its debt is $7.5 million. The treasurer estimates that the beta of the stock is currently 1.8 and that the expected risk premium on the market is 7%. 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.)

Required return %

b. Estimate the company cost of capital. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Cost of capital %

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.)

Discount rate %

d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical manufacturers is 1.05. 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 %

Answer 1

a.   the required return on Okefenokee stock = Risk Free Rate + Beta *(Market Return - Risk Free Rate) = 3% + 1.8*7% = 15.6%

b. Cost of Capital = Weight of Equity * Cost of Equity + Weight of Debt* Cost of Debt = 11.5/(11.5+7.5)*15.6%+ 7.5/(11.5+7.5)*3% =  10.63%

c. The cost of capital and discount rate are same Hence Discount rate = 10.63%

d. The required Rate on Okefenokee stock = Risk Free Rate + Beta *(Market Return - Risk Free Rate) = 3% + 1.05*7% = 10.35%

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