2. The Goodtread Rubber Company has the following two divisions. Tire Division -

Question

2. The Goodtread Rubber Company has the following two divisions. Tire Division -- which manufactures tires for new autos (1) (ii) Recap Division -- which manufactures recapping materials that are sold to independent recapping shops. Since auto manufacturing moves up and down with the general economy, the Tire Division's earnings contribution to Goodtread's stock price is highly correlated with the returns on most other stocks. If the Tire Division was operated as a separate company the beta of its assets would be 1.60. The sales and earnings of the Recap Division, on the other hand, are not as cyclical since recap sales are high when people cannot afford to buy new tires. The beta of Recap's assets is 0.40. Approximately 75% of Goodtread's corporate assets are in the Tire Division and 25% in the Recap Division. Goodtread has a debt/equity ratio of 0.5. Its debt is risk free. Currently, the risk free rate is 5% and the expected return on the market portfolio is 12%. There are no taxes and the assumptions of the CAPM are satisfied. (a) What is the required rate of return on Goodtread's stock? (b) What discount rate should Goodtread use to evaluate capital budgeting projects? Explain your answer.

Explanation / Answer

Required rate of return will be the weighted average of 2 separate entities

Required rate of return on Tire division

Re = Rf + Beta*(Rm-Rf)

Re = 5% + 1.6*(12%-5%) = 5% + 11.2% = 16.2%

Required rate of return on Recap division

Re = 5% + 0.4*(12%-5%) = 5% + 2.8% = 7.8%

Now 75% is the Tire weightage and 25% is the Recap weightage

So Required return on Stock = 75%*16.2% + 25%*7.8% = 12.15% + 1.95% = 14.1%

2) Discount rate that Goodtread should use to evaluate capital budgeting projects should be 14.1% as for the combined assets, this is the required rate of return on Goodtread's stock.

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