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    Okefenokee Real Estate Company

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    The total market value of Okefenokee Real Estate Company 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 percent. The Treasury bill rate is 4 percent.

    a. What is the required rate of return on Okefenokee stock?

    b. What is the beta of the company's existing portfolio of assets? The debt is perceived to be virtually risk-free.

    c. Estimate the company's cost of capital assuming a tax rate of 40 percent.
    d. Estimate the discount rate for an expansion of the company's present business.
    e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.2. What is the required rate of return on Okefenokee's new venture?

    Solution

    Problem 11-18
    Instructions

    Enter formulas to solve the requirements of this problem.

    Treasury bill rate 4%
    Stock beta 1.50
    Risk premium 10%

    a. What is the required rate of return on Okefenokee stock?
    Required rate of return on the stock FORMULA

    b. What is the beta of the company's existing portfolio of assets? The debt is perceived to be virtually risk-free.
    Beta FORMULA

    c. Estimate the company's cost of capital assuming a tax rate of 40 percent.
    After tax
    Cost cost Proportions WACC
    Debt FORMULA 40% 0.00%
    Equity 60% 0.00%
    0.00%

    d. Estimate the discount rate for an expansion of the company's present business.

    e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.2. What is the required rate of return on Okefenokee's new venture?

    Rate FORMULA

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    Solution Preview

    The total market value of Okefenokee Real Estate Company 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 percent. The Treasury bill rate is 4 percent.

    a. What is the required rate of return on Okefenokee stock?

    b. What is the beta of the company's existing portfolio of assets? The debt is perceived to be virtually risk-free.
    c. Estimate the company's cost of capital assuming a tax rate of 40 percent.
    d. Estimate the discount rate for an expansion of the company's present business.
    e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The ...

    Solution Summary

    This solution is comprised of a detailed explanation to answer what is the required rate of return on Okefenokee stock, what is the beta of the company's existing portfolio of assets? The debt is perceived to be virtually risk-free, estimate the company's cost of capital assuming a tax rate of 40 percent, estimate the discount rate for an expansion of the company's present business, and what is the required rate of return on Okefenokee's new venture.

    $2.19

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