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1. The total market value of the common stock of the Okefenokee

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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?
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 spectacles.
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.

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

Table 9.1
_equity Error
Burlington Northern & Santa Fe .53 .20
CSX Transportation .58 .23
Norfolk Southern .47 .28
Union Pacific Corp. .47 .19
Industry portfolio .49 .18
TA B L E 9.1
Estimated betas and costs of (equity) capital for a
sample of large railroad companies and for a
portfolio of these companies, based on monthly
returns from 1999–2003. The precision of the
portfolio beta is better than that of the betas of
the individual companies—note the lower
standard error for the portfolio.

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.

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

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?

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