Question
Jed's Best, an all equity financed firm, has traditionally employed a firm-wide discount rate for capital budgeting purposes. The firm consists of two divisions, restaurant
Jed's Best, an all equity financed firm, has traditionally employed a firm-wide discount rate for capital budgeting purposes. The firm consists of two divisions, restaurant management and restaurant ownership. Therefore, the firm may be considered a portfolio of these two divisions.Its two divisions, restaurant management and restaurant ownership have different degrees of risk given by M = 1.1, R = 1.8, while the beta for the overall firm is 1.3. The restaurant management division has proposed three projects with these internal rates of return: M1 = 13.2 percent; M2 = 12.4 percent; and M3 = 9.8 percent. The restaurant ownership division has presented their three projects: R1 = 16.4 percent; R2 = 17.8 percent; and R3 = 14.7 percent. The risk-free rate is 4 percent and the market risk premium is 8 percent.
a. What weights would you assign to each of the two divisions?
b. Identify which projects will be accepted if the firm uses the firm's cost of capital to evaluate all projects.
c. What projects do you suggest that the firm accept and why?
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