11.

(from BMA Chapter 9) The total market value of the common stock of the
Okefenokee Real Estate Company is $6 million, and the total vale 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%. The treasury bill rate is 4%.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 companys present business?
d. Suppose the company wants to diversify into the manufacture of rose-colored
spectacles. The beta of unleveraged optical manufactures is 1.2. Estimate the
required return on Okefenokees new venture.


Solution
a. r
equity
= r
f
+ | (r
m
r
f
) = 0.04 + (1.5 0.06) = 0.13 = 13%

b. |
.
|

\
|
+ |
.
|

\
|
= + = 0.13
$10million
$6million
0.04
$10million
$4million
r
V
E
r
V
D
r
equity debt assets

r
assets
= 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. The systematic risk for optical manufacturers, |
A
= 1.2.
If we lever up the equity beta for Okefenokee,
|
E
= (1+D/E)( |
A
) = (1.67)*1.2 = 2
r
equity
= r
f
+ |
E
(r
m
r
f
) = 0.04 + (2 0.06) = 0.16 = 16%
|
.
|

\
|
+
|
.
|

\
|
= + = 0.16
$10million
$6million
0.04
$10million
$4million
r
V
E
r
V
D
r
equity debt assets

r
assets
= 0.112 = 11.2%


12. (from BMA Chapter 9) Nero Violins has the following capital structure:

Security

Beta
Total Market Value
($ millions)
Debt 0 $100
Preferred Stock 0.2 40
Common Stock 1.20 299

a. What is the firms asset beta?
b. Assume that the CAPM is correct. What discount rate should Nero set for
investments that expand the scale of its operations without changing its asset
beta? Assume a risk-free rate of 5% and a market risk premium of 6%.

Solution
a.
0.836
n $439millio
n $299millio
1.20
n $439millio
$40million
0.20
n $439millio
n $100millio
0
V
C

V
P

V
D

common preferred debt assets
=
|
.
|

\
|

|
.
|

\
|
+
|
.
|

\
|

= |
.
|

\
|
+ |
.
|

\
|
+ |
.
|

\
|
=


b. r = r
f
+ | (r
m
r
f
) = 0.05 + (0.836 0.06) = 0.10016 = 10.016%



14. (from BMA Chapter 9) You are given the following information for Golden Fleece
Financial:
Long-term debt outstanding $300,000
Current yield to maturity 8%
Number of shares of common stock 10,000
Price per share $50
Book value per share $25
Expected rate of return on stock 15%

Calculate Golden Fleeces company cost of capital. Ignore taxes.

Solution
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,
Golden Fleeces weighted-average cost of capital is:
0.15
500,000 300,000
500,000
0.08
500,000 300,000
300,000
r
assets

|
|
.
|

\
|
+
+
|
|
.
|

\
|
+
=
r
assets
= 0.124 = 12.4%


A diversified firm with investments in many industries is considering investing in the
fast-food industry. The diversified firm is financed by 60% equity and 40% risk-free
debt. By looking at data on publicly traded fast-food companies, an analyst discovers the
following information for McDonalds Corporation and Wendys International Inc.

The market risk premium is 5%
The debt beta for McDonalds and Wendys is zero
The equity betas are 0.8 for Wendys and 1.0 for McDonalds
Wendys has a debt-to-equity ratio of 0.15, and McDonalds has a ratio of 0.25
The risk free rate is 5%

Calculate the asset betas for McDonalds and Wendys, ignoring taxes. Using this
information, find the cost of capital for the new investment in the fast-food business.

For Wendys

A
=
e
/(1+(D/E)) = 0.8/(1+0.15) = 0.70

For McDonalds

A
=
e
/(1+(D/E)) = 1/(1+0.25) = 0.80

The average
A
is 0.75

For the diversified firm,

e
=
A
*(1+(D/E)) = 0.75*(1+0.67) = 1.25

r
e
= r
f
+
e
*(Market Premium) = 5% + 1.25*5% = 11.25%

WACC = 5%*0.4 + 11.25%*0.6 = 8.75%