d mix so, with X or Y? 2. The Goodtread Rubber following two divisions. Company

Question

d mix so, with X or Y? 2. The Goodtread Rubber following two divisions. Company has the (i) Tire Division which manufactures tires for new utos 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. 3. Western Airline has decided to raise $5M

Explanation / Answer

a. Cost of equity using CAPM= risk free rate + beta* (market return-risk free rate) = 5%+ 1.3(12%-5%)= 14.1%

b. discount rate to be used is weighted average cost of capital:

Cost of equity = 14.1%

Cost of debt= 5%

Division Beta Weight Weighted beta Tire 1.6 75% 1.20 Recap 0.4 25% 0.10 Beta of company 1.30

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