Newtown Propane currently has only a wholesale division and uses only equity cap

Question

Newtown Propane currently has only a wholesale division and uses only equity capital; however, it is considering creating marketing and retail divisions. Its beta is currently 1.2. The marketing division is expected to have a beta of 1.8, because it will have more risk than the firm's wholesale divison. The retail division is expected to have a beta of 0.7, because it will have less risk than the firm's wholesale division. The risk-free rate is 3.6%, and the market-risk premium is 5.2%. Based on this information, fill in the missing information in the following below

Wholesale Division options: a. 7.20% b. 7.92% c. 3.60% d. 9.84%

Marketing Division options: a. 14.91% b. 12.96% c. 13.91% d. 15.46%

Retail Division options: a. 13.71% b. 14.91% c. 7.24% d. 15.01%

If 75% of Newtown Propane's total value ends up in the wholesale divison, 10% in the marketing division, and 15% in the retail division, then its investors should require a return of __________. (a. 11.09%, b. 12.64%, c. 14.54%, d. 9.79%)

Explanation / Answer

CAPM,Required return = Rf + [Beta * market risk premium]

wholesale division, Rs = 3.6 + [1.2 * 5.2]

                                 = 3.6 + 6.24

                                 = 9.84 %

correct option is "D"

Marketing division = 3.6 + [1.8 * 5.2]

                            = 3.6 + 9.36

                           = 12.96%

correct option is "B"

Retail division = 3.6 + [.7 *5.2 ]

                     = 3.6 + 3.64

                     = 7.24%

correct option is "C" -7.24%

Require return = (.75 *9.84) +(.10 * 12.96) +(.15 * 7.24)

                       = 7.38+ 1.296+ 1.086

                       = 9.762 % (approx 9.79%)

correct option is "D"

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