5. Correct Answer: E. 13% Working note: For Heavy Metal Mining, 15% = Risk free

Question

5.

Correct Answer:

E. 13%

Working note:

For Heavy Metal Mining,

15% = Risk free return + beta*(Market return – risk free return)    (as per the CAPM model)

15% = 4% + 1.1*(Market return - 4%)  

Market return= (15%-4%)/1.1 + 4% = 14%

For the division, let the cost of equity = K

K = 4% + .9*(Market return - 4%)

K = 4% + .9*(14% - 4%)

K = 13%

6.

Correct Answer:

B.10.8%

Since the minimum required rate of return is the cost of capital and it is 10.8% for the business of water features and fountains, then sister pools should take 10.8% as cost of capital for the new business of water features and fountains.

Explanation / Answer

5. The Heavy Metal Mining has an overall cost of equity of 15 percent and a beta of 1.1. The firm is financed solely with common stock. The risk-free rate of return is 4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 0.9? ·5.5% 8.3% A C 10.8% D 12.5% E 13.0% Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.8 percent. Sister Pools is considering building and selling its own water features and fountains. Wha 6 t is an appropriate cost of capital for this project? A 11.6% B 10.8% C 9.5% D 8.4% 6.7%

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