Suregrip Rubber company has two divisions: 1) the tire division, which manufactu
ID: 2674788 • Letter: S
Question
Suregrip Rubber company has two divisions: 1) the tire division, which manufactures tires for new autos, and (2) the recap division, which manufactures recapping materials that are sold to independent tire recapping shops throughout the US. Since auto-manufacturing fluctuates with the general economy, the tire division's earnings contribution to Suregrip's stock price is highly correlated with returns on most other stocks. If the tire division were operated as a seperate company, its beta coefficient would be about 1.6. The sales and profits of the recap division, on the otherhand, tend to be countercyclical, since recap sales boom when people cannot afford to buy new tires. The recap divisions beta is estimated to be .4. Approximately 75% of Suregrips corporate assets are invested in the tire division and 25% are in the recap division.
Currently, the rate of interest of treasury bonds is 10%, and the expected rate of return on an average share of stock is 15%. Suregrip uses only common equity capital, hence, it has no debt outstanding.
a) what is the required rate of return on Surgrip's stock?
b) what discount rate should be used to evaluate capital budgeting projects? Explain your answer fully, and in the process, illustrate you answer with a project which costs $100,000, has a 10-yr life and provides expected after-tax net cash flows of $20,000 per year.
Explanation / Answer
a)
beta of company = weighted average of division betas
= 75%*1.6 + 25%*0.4
= 1.3
risk free rate rf= interest on treasury bonds = 10%
req rate of return of avg stock = 15%
req rate of avg stock = rf + avg beta*market risk premium
15% = 10% * 1.3*market risk premium
market risk premium = 3.846%
req rate of sure grip = rf + suregrip beta * market risk premium
= 10% + 1.6*3.846%
=16.154%
b)
required rate on the division should be used for capital budgeting projects.
the pv of after tax cash flows of 20000 for 10 years at required rate r
= 20000*[1-(1+r)^-10]/r
if this is greater than the initial cost of 100000, the project is profitable.
if this 100000 is invested in the suregrip division, the sure grip req rate should be used, or recap rate should be used if it is invested in recap. If it is a diverse investment in both projects, then avg rate should be calculated using the weigted avg of beta of divisions, based on the investment split in the divisions.
Please rate my answer!
thanks in advance :)
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