Given Information: Performance Rubber Company has two divisions: the tire divisi

Question

Given Information:

Performance Rubber Company has two divisions: the tire division, which manufactures tires for new autos, and the recap division, which manufactures recapping materials that are sold to independent tire recapping shops. Since auto manufacturing fluctuates with the general economy, the tire division’s earnings contribution to Performance’s stock price is highly correlated with returns on most other stocks. If the tire division were operated as a separate company, its beta coefficient would be 1.50. The sales and profits of the recap division tend to be countercyclical, because recap sales boom when people cannot afford to buy new tires. The recap division’s beta is estimated to be 0.5. Approximately 75 percent of Performance’s corporate assets are invested in the tire division and 25 percent are invested in the recap division.

Currently, the rate of interest on short-term treasurys is 9 percent (rRF = 9%), and the expected rate of return on an average share of stock is 13 percent (rM = 13%). Performance uses only common equity capital, so it has no debt outstanding.

Question: What is the cost of capital for projects in each division?

Explanation / Answer

* Cost of capital for tire division= Cost of equity for tire division

= 9% + 1.5 * Market Premium

And Market Premium= rM= rRF= 13%- 9%= 4%

Cost of capital for tire division=  9% + 1.5 * 4%

= 9%+ 6%= 15%

*Cost of capital for recap division= Cost of equity for recap division

= 9% + .5 * Market Premium

= 9% + .5 *4%

=11%

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