(Divisional Market Risk Adjustment) SureGrip Rubber Company has two divisions:
(1) the tire division, which manufactures tires for new autos, and (2) the recap division, which manufactures recapping materials that are sold to independent tire recapping shops throughout the United States. Since auto manufacturing fluctuates with the general economy, the tire divisionâ??s earnings contribution to SureGripâ??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 about 1.60. The sales and profits of the recap division, on the other hand, tend to be countercyclical, since recap sales boom when people cannot afford to buy new tires. The recap divisionâ??s beta is estimated to be 0.40. Approximately 75% of SureGripâ??s corporate assets are invested in the tire division and 25% are in the recap division.
Currently, the rate of interest on Treasury bonds is 10%, and the expected rate of return on the average share of stock is 15%. SureGrip uses only common equity capital, hence it has no debt outstanding.
a. What is the required rate of return on SureGripâ??s stock?
b. What discount rate should be used to evaluate capital budgeting projects? Explain your answer fully, and in the progress, illustrate your answer with a project which costs $100,000 has a 10-year life, and provides expected after-tax net cash flows of $20,000 per year.
Required rate of return is examined.