Question: A firm has the following capital structure:
Debt 40%
Equity 60%
The current yield on long-term government bonds is 9 percent, the interest rate on the firm's debt is 12 percent, and the expected yield on the market portfolio is 15 percent. The firm has a beta of 1 .2, and its tax rate is 40 percent. Issuing and underwriting expenses can be ignored, so that k, = r,. The firm consists of 2 divisions of roughly equal size, one of which manufactures consumer goods, and the other is engaged in the production of industrial capital equipment. The consumer products division has a comparatively lower risk than the industrial equipment division. Independent competitors who operate solely in consumer goods tend to have a capital structure of 50-percent debt and 50-percent common equity, with a beta of 1 for their equity.
(a) What discount rates would you use to evaluate new investments in the consumer products and the industrial equipment divisions?
(b) What capital structure would you expect for independent competitors who operate solely in industrial equipment, and what value of beta would you anticipate for their equity?