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Corporate Finance MT480

Prof. Weaver

CHAPTER 9 PQ: 1,7,8a, 8c and 11

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.

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%.

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%
D E $4million $6million
r assets =
V V (
r debt + r equity=
$10million )(
×0 . 04 +
$10million )
×0 . 112

rassets = 0.0832 = 8.32%

The beta of unleveraged optical manufacturers is 1.2. Estimate the required

return on Okefenokee’s new venture.
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:

r assets= (300,000
300,000 + 500,000 ) × 0. 08 + (
500,000
300,000 + 500,000 )
× (0 .15 )

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.

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%

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.

a. Expected production for the day =

(0.2  0) + 0.8  [(0.4 x 1,000) + (0.6 x 5,000)] = 2,720 barrels
Expected cash revenue for the year = 2,720 x 365 x $15 = $14,892,000

b. Possibility of a dry hole is a diversifiable risk therefore shouln’t affect the

discount rate. This possibility should affect forecasted cash flows, however.
See Part (a).

CHAPTER 10 PQ: 4 and 5

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:
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Pessimistic Expected Optimistic

Sales, millions of welts .4 .5 .7

Manufacturing cost with new

machinery, dollars per welt 6 4 3

Economic life of new

machinery, years 7 10 13

Conduct a sensitivity analysis of the replacement decision, assuming a discount rate of

12 percent. Rustic Welt does not pay taxes.
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. Economic life of the new machine is expected to last for 10 years, so the
equivalent annual cost of the new machine is:
$9/5.6502 = $1.59
ii. Manufacturing cost is Reduced
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:
Equivalent Annual Cost Savings (Millions)

Pessimistic Expected Optimistic

Sales 0.01 0.41 1.21

Manufacturing Cost -0.59 0.41 0.91

Economic Life 0.03 0.41 0.60

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?