World Corporation has traditionally employed a firm-wide discount rate for capit

Question

World Corporation has traditionally employed a firm-wide discount rate for capital budgeting purposes. However, its two divisions - publishing and entertainment - have different degrees of risk given by P = 1.1, E = 1.8, while the beta for the overall firm is 1.3. The publishing division has proposed three projects with these internal rates of return: P1 = 13.2 percent; P2 = 12.4 percent; and P3 = 9.8 percent. The entertainment division has presented their three projects: E1 = 16.4 percent; E2 = 17.8 percent; and E3 = 14.7 percent. The risk-free rate is 4 percent and the market risk premium is 8 percent.

a.       Identify which projects will be accepted if the firm applies its overall beta to all projects.

b.       Then identify which projects will be accepted if the division betas are properly applied.

c.       Explain the likely reasons for the three betas having differing values.

Explanation / Answer

a)

Expected return on equity = Rf + Beta * MRP = 4% + 1.3* 8% = 14.4%

If firm applies overall beta, then it can accept Projects E1, E2 and E3(As IRR of (E1,E2,E3)> Cost of capital assuming that these projects are independent.

b)

Expected return on equity for Publishing division = 4% + 1.1* 8% = 12.8%

From Publishing division it can accept P1 as IRR of P1 > Cost of Equity capital

Expected return on equity for Entertainment division = 4% + 1.8* 8% = 18.4%

None of Entertainment division projects can be accepted as IRR< Cost of capital

c)

Beta is a measure of systematic risk or in other words the volatility of division returns with respect to the market as a whole. In the above case Entertainment divisions high Beta signifies a higher volatility of returns viz a viz market returns where as the Publishing divisions low beta signifies a lower risk as correlated to market risk. The overall firm risk will be weighted average of individual risk and as 1.3 is closer to the beta of Publishing division one can conclude that the firm gets majority of its revenues from publishing division and hence the risk has been reduced compared to the entertainment division risk.

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