World Corporation Has Traditionally Employed a Firm-Wide Discount Rate for Capital

question 64

Essay

World Corporation has traditionally employed a firm-wide discount rate for capital budgeting purposes.However,its two divisions,publishing and entertainment,have different degrees of risk given by β_P = 1.1,β_E = 1.8,while the beta for the overall firm is 1.3.The publishing division has proposed three projects with these internal rates of return: P₁ = 13.2 percent; P₂ = 12.4 percent; and P₃ = 9.8 percent.The entertainment division has presented their three projects: E₁ = 16.4 percent; E₂ = 17.8 percent; and E₃ = 14.7 percent.The risk-free rate is 4 percent and the market risk premium is 8 percent.Identify which projects will be accepted if the firm applies its overall beta to all projects.Then identify which projects will be accepted if the division betas are properly applied.

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Definitions:

Credit-Granting Policies

Guidelines established by lenders to determine the criteria and conditions under which credit is extended to borrowers.

Vertical Analysis

An accounting method where each entry in a financial statement is listed as a percentage of another item, typically used for comparing companies of different sizes or assessing trends within a single company over time.

Cost of Goods Sold

The direct expenses related to the manufacturing of products that a company sells.

Current Ratio

A liquidity measure that evaluates a company's ability to pay short-term obligations, calculated as current assets divided by current liabilities.