Question

Suppose that you are evaluating a project in the food division. What is the appropriate discount rate for this project? Assume that the CAPM holds. The risk-free rate is 1% and the expected return on the market is 7%

Answer 1

Answer:

Find below complete question:

There are three equally large divisions in a conglomerate: (i) food division, (ii) travel division, and (iii) construction division. Their divisional betas are 0.5, 1.8, and 2.2, respectively.

What is the overall beta for the entire firm?

A.0.5

B.1.8

C.1.5

D.2.2

Correct option is C,1.5

Suppose that you are evaluating a project in the food division. What is the appropriate discount rate for this project? Assume that the CAPM holds. The risk-free rate is 1% and the expected return on the market is 7%.

A.10%

B.11.8%

C.4%

D.14.2%

Correct option is A,10%

Explanation:

The starting point is to determine the overall beta for the company.

Since all the three divisions are equally large,it means they share the same probability weighting of 0.3333(1/3)

food division               0.3333 *0.5

Travel division             0.3333*1.8

construction                 0.3333*2.2

overall beta                  1.49985  

1.5 approx

Ke=Rf+beta(Rm-Rf)

Rf is the risk free rate of 1%

Rm is the expected return on market of 7%

beta is 1.5

Ke=1%+1.5*(7%-1%)

Ke=10%