(b) The Pioneer Company has two divisions: health foods and specialty metals. Each division employs debt equal to 30 percent and preferred stock equal to 10 percent of its total requirements, with equity capital used for the remainder. The current borrowing rate is 15 percent, and the company's tax rate is 40 percent. At present, preferred stock can be sold yielding 13 percent. Pioneer wishes to establish a minimum return standard for each division based on the risk of that division. This standard then would serve as the transfer price of capital to the division. The company has thought about using the capital-asset pricing model in this regard. It has identified two samples of companies, with modal value betas of 0.90 for health foods and 1.30 for specialty metals. (Assume that the sample companies had similar capital structures to that of Pioneer.) The risk-free rate is currently 12 percent and the expected return on the market portfolio 17 percent. Required: Using the CAPM approach, what weighted average required returns on investment would you recommend for these two divisions?
(b) The Pioneer Company has two divisions: health foods and specialty metals. Each division employs debt equal to 30 percent and preferred stock equal to 10 percent of its total requirements, with equity capital used for the remainder. The current borrowing rate is 15 percent, and the company's tax rate is 40 percent. At present, preferred stock can be sold yielding 13 percent. Pioneer wishes to establish a minimum return standard for each division based on the risk of that division. This standard then would serve as the transfer price of capital to the division. The company has thought about using the capital-asset pricing model in this regard. It has identified two samples of companies, with modal value betas of 0.90 for health foods and 1.30 for specialty metals. (Assume that the sample companies had similar capital structures to that of Pioneer.) The risk-free rate is currently 12 percent and the expected return on the market portfolio 17 percent. Required: Using the CAPM approach, what weighted average required returns on investment would you recommend for these two divisions?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:(b) The Pioneer Company has two divisions: health foods and specialty metals. Each division
employs debt equal to 30 percent and preferred stock equal to 10 percent of its total
requirements, with equity capital used for the remainder. The current borrowing rate is 15
percent, and the company's tax rate is 40 percent. At present, preferred stock can be sold
yielding 13 percent.
Pioneer wishes to establish a minimum return standard for each division based on the risk of
that division. This standard then would serve as the transfer price of capital to the division.
The company has thought about using the capital-asset pricing model in this regard. It has
identified two samples of companies, with modal value betas of 0.90 for health foods and
1.30 for specialty metals. (Assume that the sample companies had similar capital structures
to that of Pioneer.)
The risk-free rate is currently 12 percent and the expected return on the market portfolio 17
percent.
Required:
Using the CAPM approach, what weighted average required returns on investment would
you recommend for these two divisions?
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