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Ques 1- The asset betas for the various divisions have been computed as follows: Risk free rate: Risk free rate considered is the U.S. Government interest rates. For divisions with shorter useful life of assets, the US government interest for 10 years as of April 1988 has been used (short term rate for restaurants and contract services) and for division with the assets with long useful lives, the US government interest for 30 years has been considered (long term rate for Lodging). Since the information for US government interest rates for different maturities is available it has been considered, in the absence of this information we can take the short term treasury bill rate. Market risk premium (MRP=Market return- Risk free rate): The…show more content…
Since only contract services industry provide a return above this threshold, any future projects in lodging and restaurants industry which achieve the threshold for the returns in that industry will be ignored unless they achieve a return of 12.02%. This would result in the INCREASE in the total assets under contract services division of the company and a DECLINE in the proportion of assets for the other division. With the passage of time, the company will stop taking any projects in other divisions and would exclusively handle the contract services division, this would result in a decline in the value of the firm since the contract services industry contributes lesser to the total profits of the firm compared to its contribution in sales (For 1987, contract services contributed to 46% in sale and 33% in profits as against 41% and 51% for lodging and 13% and 16% for restaurants). Also this would result in the company taking up the riskiest projects in the industry. VALUE OF BUSINESS OVER TIME: As a result of the above, there will be incorrect allocation of capital between the divisions, resulting in reduced value of the company. Also, since a single rate will be used to discount the cash flows from less riskier divisions (lodging), this too would result in lower valuation

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