The Sprouts-N-Steel Company has two divisions: health foods

The Sprouts-N-Steel Company has two divisions: health foods and specialty metals. Each division employs debt equal to 30 percent and preferred stock equal to 10 percent of its total requirements, with equity capital used for the remainder. The current borrowing rate is 15 percent, and the company’s tax rate is 40 percent. At present, preferred stock can be sold yielding 13 percent.

Sprouts-N-Steel wishes to establish a minimum return standard for each division based on the risk of that division. This standard then would serve as the transfer price of capital to the division. The company has thought about using the capital-asset pricing model in this regard. It has identified two samples of companies, with modal value betas of 0.90 for health foods and 1.30 for specialty metals. (Assume that the sample companies had similar capital structures to that of Sprouts-N-Steel.) The risk-free rate is currently 12 percent and the expected return on the market portfolio 17 percent. Using the CAPM approach, what weighted average required returns on investment would you recommend for these two divisions?


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