2. A company has three divisions and each division has several available project
ID: 2819503 • Letter: 2
Question
2. A company has three divisions and each division has several available projects as shown below. All of the projects are independent and all have normal cash flows. The company's beta is 1.3, the risk-free rate of interest is 5% per year, and the equity risk premium is 6% per year. The company is financed entirely with equity and its tax rate is 30%. Companies in the same business as division X have an average beta of 1.8, companies in the same business as division Y have an average beta of 1.4, and companies in the same business as division Z have an average beta of 0.8. Which projects should the company pursue? Project Internal rate of return Division A 12.1% Z B 10.3 Y C 16.2 X D 10.4 Z E 13.1 Y F 12.8 X G 11.9 Z H 13.7 Y
Explanation / Answer
2. the cost of equity capital for the companies in division X is :
as per the CAPM formula
cost of equity = risk free rate + beta * equity riks premium ,
as per the problem,
Rf + b(Rm - Rf )= 5 + 1.8*6 = 15.8
therefore, the company should pursue Project C, as the project with an IRR> cost of capital that is 16.2 >15.8, this project will be favourable to pursue. so the company should pursue Project C.
the cost of capital for division Y is :
= 13.4
only Project H , fulfills the criteria, so the company should pursue Project H. The IRR of 13.7 is greater than the cost of capital for division Y which is of 13.4%
Now we calculate the cost of equity for division Z:
we get the cost of equity as 9.8 %
the projects that should be pursued by the company are :
project A which has an IRR of 12.1 which is greater than the cost of capital.
project D, which has an IRR of 10.4>9.8
and Project G,which has an IRR of 11.9> 9.8 ,the cost of equity of division Z.
Thd p
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.