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? b. Estimate the company cost of capital. c. What is the discount rate
for an expansion of the company’s present business? d. Suppose the company wants to
diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical
manufacturers is 1.2. Estimate the required return on Okefenokee’s new venture.
1.
a.
requity = rf +   (rm – rf) = 0.04 + (1.5  0.06) = 0.13 = 13%
b.
rassets 
D
E
 $4million
  $6million

rdebt  requity  
 0.04   
 0.13 
V
V
 $10million
  $10million

rassets = 0.094 = 9.4%
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.
requity = rf +   (rm – rf) = 0.04 + (1.2  0.06) = 0.112 = 11.2%
rassets 
D
E
 $4million
  $6million

rdebt  requity  
 0.04   
 0.112 
V
V
 $10million
  $10million

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.
The total market value of outstanding debt is $300,000. The cost of debt capital is 8
percent. For the common stock, the outstanding market value is:
$50  10,000 = $500,000. The cost of equity capital is 15 percent. Thus,
Lorelei’s weighted-average cost of capital is:




300,000
500,000
  0.08  
  (0.15 )
rassets  
 300,000  500,000 
 300,000  500,000 
rassets = 0.124 = 12.4%
8. Look again at Table 9.1. This time we will concentrate on Burlington Northern. a.
Calculate Burlington’s cost of equity from the CAPM using its own beta estimate and the
industry beta estimate. How different are your answers? Assume a risk-free rate of 3.5
percent and a market risk premium of 8 percent. b. Can you be confident that
Burlington’s true beta is not the industry average? c. Under what circumstances might
you advise Burlington to calculate its cost of equity based on its own beta estimate?
a.
rBN = rf + BN  (rm – rf) = 0.035 + (0.53  0.08) = 0.0774 = 7.74%
rIND = rf + IND  (rm – rf) = 0.035 + (0.49  0.08) = 0.0742 = 7.42%
No, we can not be confident that Burlington’s true beta is not the
industry average. The difference between BN and IND (0.04) is less
than one standard error (0.20), so we cannot reject the hypothesis that
BN = IND.
c. Burlington’s beta might be different from the industry beta for a variety of
reasons. For example, Burlington’s business might be more cyclical than is the case
for the typical firm in the industry. Or Burlington might have more fixed operating
costs, so that operating leverage is higher. Another possibility is that Burlington has
more debt than is typical for the industry so that it has higher financial leverage
b.
11. An oil company is drilling a series of new wells on the perimeter of a producing oil
field. About 20 percent of the new wells will be dry holes. Even if a new well strikes oil,
there is still uncertainty about the amount of oil produced: 40 percent of new wells that
strike oil produce only 1,000 barrels a day; 60 percent produce 5,000 barrels per day. a.
Forecast the annual cash revenues from a new perimeter well. Use a future oil price of
$15 per barrel. b. Ageologist proposes to discount the cash flows of the new wells at 30
percent to offset the risk of dry holes. The oil company’s normal cost of capital is 10
percent. Does this proposal make sense? Briefly explain why or why not.
a.
Expected daily production =
(0.2  0) + 0.8  [(0.4 x 1,000) + (0.6 x 5,000)] = 2,720 barrels
Expected annual cash revenues = 2,720 x 365 x $15 = $14,892,000
b.
The possibility of a dry hole is a diversifiable risk and should not
affect the discount rate. This possibility should affect forecasted cash
flows, however. See Part (a).
Chapter 10 4. The Rustic Welt Company is proposing to replace its old welt-making
machinery with more modern equipment. The new equipment costs $9 million (the
existing equipment has zero salvage value). The attraction of the new machinery is that it
is expected to cut manufacturing costs from their current level of $8 a welt to $4.
However, as the following table shows, there is some uncertainty both about future sales
and about the performance of the new machinery:
If Rustic replaces now rather than in one year, several things happen:
i. It incurs the equivalent annual cost of the $9 million capital investment.
ii. It reduces manufacturing costs.
For example, for the “Expected” case, analyzing “Sales” we have (all dollar
figures in millions):
i.
The economic life of the new machine is expected to be 10 years, so the
equivalent annual cost of the new machine is:
$9/5.6502 = $1.59
ii.
The reduction in manufacturing costs is:
0.5  $4 = $2.00
Thus, the equivalent annual cost savings is:
–$1.59 + $2.00 = $0.41
Continuing the analysis for the other cases, we find:
Sales
Manufacturing Cost
Economic Life
Equivalent Annual Cost Savings (Millions)
Pessimistic
Expected
Optimistic
0.01
0.41
1.21
-0.59
0.41
0.91
0.03
0.41
0.60