Contemporary Financial Management
14th Edition
ISBN: 9781337090582
Author: R. Charles Moyer, James R. McGuigan, Ramesh P. Rao
Publisher: Cengage Learning
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Chapter 12, Problem 16P
Summary Introduction
To determine: The minimum
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Novus Nyet Company has two divisions: Health Foods and Specialty Metals. Each of these divisions
employs debt equal to 30 percent of its total requirements, with equity capital used for the balance. The
current borrowing rate is 8 percent, and the company's tax rate is 40 percent. Novus Nyet wishes to
establish a minimum return standard for each division based on the risk of that division. This standard
then would serve as the transfer price of capital to the division.
The company has thought about using the capital asset pricing model in this regard. It has identified two
samples of companies, with the following mode-value characteristics:
Debt/Totat
Capitalization Ratio
Tax
Rate
Beta
Health Foods
90
.50
.40
Specialty Metals
1.25
.30
.40
Page 1 of 2
The risk-free rate presently is 6 percent, and the expected return on the market portfolio 11 percent. Using
the CAPM approach, what required returns on investment would you recommend for these two divisions?
Ace Enterprises Limited is a large company involved in production and sale of petroleum products. The Finance Department of the company is trying to determine the company’s optimal capital structure. The firms’ financial advisors have developed the following table:
Equity Ratio
Debt Ratio
Before Tax Cost of Debt
100%
0%
7%
80%
20%
8%
60%
40%
10%
40%
60%
12%
20%
80%
15%
The company uses and applies the Capital Assets Pricing Model to estimate its cost of common equity. The company estimates that the risk free rate is 4.0%. The market risk premium is 6.0%, and its tax rate is 30 percent. The company estimates that if it had no debt, its unlevered beta would be 1.2.
Required:
A. Based on the above information, what is the firm’s optimal capital structure?
B. What would the weighted average cost of capital be at the optimal capital structure?
C. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit…
You are helping XYZ — a 100°/0 equity financed diversified industrial group - on the required rate of return it should be using to evaluate the performance of its various business divisions. XYZ has three divisions — Ceramics, Sanitary equipment, and Solar panels — with similar asset base. The beta values of (the listed firms comparable to) each division are as follows: • Ceramics 2.0 • Sanitary equipment 1.2 • Solar panels 2.5 (a) Estimate the cost of equity for the firm and for each division assuming a risk free rate of 10% and market risk premium of 6%. (b) The capital budgeting department uses XYZ's composite beta to fix the required rate of return on projects proposed by any division. How might this standard distort capital allocation decisions across different divisions?
Chapter 12 Solutions
Contemporary Financial Management
Ch. 12 - Prob. 1QTDCh. 12 - Prob. 2QTDCh. 12 - Prob. 3QTDCh. 12 - Prob. 4QTDCh. 12 - Prob. 5QTDCh. 12 - Prob. 6QTDCh. 12 - Prob. 7QTDCh. 12 - Prob. 8QTDCh. 12 - Prob. 9QTDCh. 12 - Prob. 10QTD
Ch. 12 - Prob. 11QTDCh. 12 - Prob. 12QTDCh. 12 - Prob. 13QTDCh. 12 - Prob. 1PCh. 12 - Prob. 2PCh. 12 - Prob. 3PCh. 12 - Prob. 4PCh. 12 - Prob. 5PCh. 12 - Prob. 6PCh. 12 - Prob. 7PCh. 12 - Prob. 8PCh. 12 - Prob. 9PCh. 12 - Prob. 10PCh. 12 - Prob. 11PCh. 12 - Prob. 12PCh. 12 - Prob. 13PCh. 12 - Prob. 14PCh. 12 - Prob. 15PCh. 12 - Prob. 16PCh. 12 - Prob. 17PCh. 12 - Prob. 18PCh. 12 - Prob. 19PCh. 12 - Prob. 20PCh. 12 - Prob. 21PCh. 12 - Prob. 22PCh. 12 - Prob. 23PCh. 12 - Prob. 24PCh. 12 - Prob. 26P
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