Corp Finance Unit 6

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Chapter 9 Practice Questions 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.

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
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See Part (a).

Chapter 10 Practice Questions

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:
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.
Rustic replaces now rather than in one year: i. It incurs the equivalent annual cost of the $9 million capital investment. ii. It reduces manufacturing costs. 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 Equivalent annual cost savings is:
–$1.59 + $2.00 = $0.41 | | Equivalent Annual Cost Savings (Millions) | | | Pessimistic | | Expected | | Optimistic | Sales | | 0.01 | |

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