# It Company Cost Estimate by upn57579

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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.

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         
rassets      rdebt  requity               0.04              0.13 
V        V           \$10million          \$10million        

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 beta of unleveraged optical manufacturers is 1.2.
Estimate the required return on Okefenokee’s new venture.

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          
rassets      rdebt  requity               0.04              0.112 
V        V           \$10million          \$10million         
rassets = 0.0832 = 8.32%

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:
      300,000                     500,000     
 300,000  500,000  0.08   300,000  500,000  (0.15)
rassets                                                
                                              
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.

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%

b. Can you be confident that Burlington’s true beta is not the industry average?

No, we can not be confident that Burlington’s true beta is not the industry
average. The difference between BN and IND (0.04) is less than one standard
error (0.20), so we cannot reject the hypothesis that BN = IND

c. Under what circumstances might you advise Burlington to calculate its cost of
equity based on its own beta estimate?

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.

Expected daily production = (0.2  0) + 0.8  [(0.4 x 1,000) + (0.6 x 5,000)]
= 2,720 barrels
Expected annual cash revenues = 2,720 x 365 x \$15 = \$14,892,000

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.

The possibility of a dry hole is a diversifiable risk and should not affect the
discount rate. This possibility should affect forecasted cash flows, however. See
Part (a).

Chapter 10

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.     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
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?

From the solution to Problem 4, we know that, in terms of potential negative
outcomes, manufacturing cost is the key variable. Rustic should go ahead with the
study, because the cost of the study is considerably less than the possible annual loss
if the pessimistic manufacturing cost estimate is realized.

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