Corp Finance Unit 6

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Chapter 9 Practice Questions
1. The total market value of the common stock of the 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 is currently 1.5 and that the expected risk premium on the market is 6 percent. The Treasury bill rate is 4 percent. 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?

requity = rf + (rm – rf) = 0.04 + (1.5 0.06) = 0.13 = 13%

b. Estimate the company cost of capital.

rassets = 0.094 = 9.4%

c. What is the discount rate for an expansion of the company’s present business?
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 theappropriate rate of return is the company cost of capital. Here, the appropriatediscount rate is 9.4%. The beta of unleveraged optical manufacturers is 1.2.Estimate the required return on Okefenokee’s new venture.

d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles.

requity = rf + (rm – rf) = 0.04 + (1.2 0.06) = 0.112 = 11.2%

rassets = 0.0832 = 8.32%

7. You are given the following information for Golden Fleece Financial. Long-term debt outstanding: $300,000
Current yield to maturity (rdebt): 8%
Number of shares of common stock: 10,000
Price per share: $50
Book value per share: $25
Expected rate of return on stock (requity): 15%
Calculate Golden Fleece’s company cost of capital. Ignore taxes.

Total market value of outstanding debt is $300,000. Cost of debt capital
is 8 percent. Common stock outstanding market value is:
$50 10,000 = $500,000. Cost of equity capital is 15 percent.
Lorelei’s weighted-average cost of capital is:

rassets = 0.124 = 12.4%

8. Look again at Table 9.1. This time we will concentrate on...
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