Thunder Bay Entertainment Inc.has two separate divisions: DVD rental and sporting goods.The beta of the entire company is 1.25.The beta of the DVD rentals division is 0.8 and the beta of the sporting goods division is 1.5.The risk-free rate is 4% and the market risk premium is 7.5%.Which of the following independent projects should the company undertake?

Question

Quizplus · Accepted Answer

We can use the Capital Asset Pricing Model (CAPM) to calculate the required rate of return for each division and project, and then compare it to the expected return to determine if the project is acceptable.

First, let's calculate the required rate of return for each division:

Required rate of return for the entire company = risk-free rate + beta of the entire company * market risk premium
= 4% + 1.25 * 7.5%
= 13.125%

Required rate of return for DVD rental division = risk-free rate + beta of DVD rental division * market risk premium
= 4% + 0.8 * 7.5%
= 10.5%

Required rate of return for sporting goods division = risk-free rate + beta of sporting goods division * market risk premium
= 4% + 1.5 * 7.5%
= 15.75%

Now, let's calculate the expected return for each project and compare it to the required rate of return:

Project I: DVD rental division 
Expected return = 14%
Acceptable as the expected return is higher than the required rate of return.

Project II: DVD rental division 
Expected return = 11%
Not acceptable as the expected return is lower than the required rate of return.

Project III: Sporting goods division 
Expected return = 15.5%
Acceptable as the expected return is slightly higher than the required rate of return.

Project IV: Sporting goods division 
Expected return = 16.5%
Acceptable as the expected return is higher than the required rate of return.

Therefore, the only acceptable projects are I and III or I and IV. The best choice among these options is B, which includes Project I and III, as they have the highest expected return and meet the required rate of return.