# 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
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 | |