Question 1: A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is 8%, and the beta of the company's common stock is .5. What is the company cost of capital? What is the after-tax WACC, assuming that the company pays tax at a 35% rate?
Question 2: 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 $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity that Okefenokee debt is risk-free and the company does not pay tax.
a. What is the required return on Okefenokee stock?
b. Estimate the company cost of capital.
c. What is the discount rate for an expansion of the company's present business?
d. Suppose the company wants to diversify into the manufacture of rose-colored specta-cles. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okefenokee's new venture.
Question 3:
Cash Flows ($)
Project C0 C1 C2 C3 C4 C5 IRR (%) NPV at 10%
F -9,000 +6,000 +5000 +4000 0 0 33 3,592
G -9,000 +1,800 +1,800 +1,800 +1,800 +1,800 20 9,000
H -- -6,000 +1,200 +1,200 +1,200 +1,200 20 6,000
Part 1: Look back to the cash flows for projects F and G. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are over- stated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects' sponsors, instructs them to use a discount rate of 18%.
a. What are the projects' true NPVs?
b. What are the NPVs at the 18% discount rate?
c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)
Otobai's accounting profit:
Unit Sales Revenues Variable Fixed Depreciation Taxes Total Profit
(thousands) Years 1-10 Costs Costs Costs after Tax
0 0 0 3 1.5 -2.25 2.25 -2.25
100 37.5 30 3 1.5 1.5 36.0 1.5
200 75.0 60 3 1.5 5.25 69.75 5.25
(figures in ¥ billions except as noted)
Part 2: Suppose that the expected variable costs of Otobai's project are ¥33 billion a year and that fixed costs are zero. How does this change the degree of operating leverage? Now recompute the operating leverage assuming that the entire ¥33 billion of costs are fixed.