The current riskfree rate is 4% and the expected rate of return on the market portfolio is...

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Finance

The currentriskfree rate is 4% and the expected rate of return on the marketportfolio is 10%. The Brandywine Corporation has two divisions ofequal market value. The debt to equity ratio (D/E) is 3/7. Thecompany’s debt can be assumed to present no riskofdefault. For the last few years, the Brandy division has been usinga discount rate of 12% in capital budgeting decisions and the Winedivision a discount rate of 10%. You have been asked by theirmanagers to report on whether these discount rates are properlyadjusted for the risk of the projects in the twodivisions.
(i)What are the betas of typical projects implicit in the discountrates used by the two divisions?
(ii)You estimate that the equity beta of Brandywine is 1.6. Is thisconsistent with the equity beta implicit in the discount rates usedby the two divisions?
(iii)You estimate that the stock beta of the Korbell Brandy Corp. is1.8. This company is purely in the brandy business, its debt toequity ratio is 2/3 and its debt beta is 0.2. Based on thisinformation (and on your estimate, from section (b), ofBrandywine’s equity beta), what discount rate would you recommendfor projects in the Brandy and in the Wine divisions ofBrandywine?

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3.8 Ratings (393 Votes)

As per CAPM equation Required rate of return Re rfRmrfequity beta Where rf risk free rate4 Rm market retuen10 Re for brandy devision 12 Therefore 124104equity beta Equity beta of brandy 1333 Similarly See Answer

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The currentriskfree rate is 4% and the expected rate of return on the marketportfolio is 10%. The Brandywine Corporation has two divisions ofequal market value. The debt to equity ratio (D/E) is 3/7. Thecompany’s debt can be assumed to present no riskofdefault. For the last few years, the Brandy division has been usinga discount rate of 12% in capital budgeting decisions and the Winedivision a discount rate of 10%. You have been asked by theirmanagers to report on whether these discount rates are properlyadjusted for the risk of the projects in the twodivisions.(i)What are the betas of typical projects implicit in the discountrates used by the two divisions?(ii)You estimate that the equity beta of Brandywine is 1.6. Is thisconsistent with the equity beta implicit in the discount rates usedby the two divisions?(iii)You estimate that the stock beta of the Korbell Brandy Corp. is1.8. This company is purely in the brandy business, its debt toequity ratio is 2/3 and its debt beta is 0.2. Based on thisinformation (and on your estimate, from section (b), ofBrandywine’s equity beta), what discount rate would you recommendfor projects in the Brandy and in the Wine divisions ofBrandywine?