Question

Goodtread Rubber Company has two divisions: the tire division, which manufactures tires for new autos, and the recap division, which manufactures recapping materials that are sold to independent tire recapping shops throughout the United States. Because auto manufacturing fluctuates with the general economy, the tire division’s earnings contribution to Goodtread’s stock price is highly correlated with returns on most other stocks. If the tire division were operated as a separate company, its beta coefficient would be 1.5. The sales and profits of the recap division, on the other hand, tend to be countercyclical because recap sales boom when people cannot afford to buy new tires. The recap division’s beta is estimated to be 0.5. Approximately 75 percent of Goodtread’s corporate assets are invested in the tire division, and 25 percent are invested in the recap division. Currently, the rate of interest on Treasury securities is 6 percent, and the expected rate of return on an average share of stock is 10 percent. Goodtread uses only common equity capital, so it has no debt outstanding.
a. What is the required rate of return on Goodtread’s stock?
b. What discount rate should be used to evaluate capital budgeting projects for each division? Explain your answer fully, and, in the process, illustrate your answer with a project that costs $160,000, has a 10-year life, and provides expected after-tax net cash flows of $30,000 per year.



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  • CreatedNovember 24, 2014
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