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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.
D E $4million $6million
r assets =
V
r debt + r equity =
V (
$10million
×0 . 04 + )(
$10million
×0 . 13 )
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 the appropriate rate of return is the
company cost of capital. Here, the appropriate discount rate is 9.4%.
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:
r assets= (300,000
300,000 + 500,000 ) × 0. 08 + (
500,000
300,000 + 500,000 )
× (0 .15 )
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.
c. Under what circumstances might you advise Burlington to calculate its cost of equity
based on its own beta estimate?
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
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.
5. Rustic Welt could commission engineering tests to determine the actual improvement
in manufacturing costs generated by the proposed new welt machines. (See Practice
Question 4 above.) The study would cost $450,000. Would you advise the company to
go ahead with the study?