Boutique Booksellers is considering expanding each of its five shops to include a gourmet coffee shop. It has identified Javabean, a firm that is solely in the gourmet coffee shop business, as a possible acquisition. Javabean's market-beta is 1.25, and Boutique's market-beta is 1.60. The relevant risk-free rate is 3% and the risk premium is 7%. If Boutique decides to make the acquisition, 15% of its funds would be invested in gourmet coffee operations, and 85% would remain invested in its basic bookstore operation.
-Refer to the information above. If Boutique were to require projects coming out of the gourmet coffee shop division to earn a return based on Boutique's overall cost of capital after the
Acquisition, which of the following would occur?
A)Bad projects coming out of the gourmet coffee shop division would be accepted.
B)Management of the gourmet coffee shop division would be restricted to investing only in the least risky projects possible.
C)Good projects coming out of the gourmet coffee shop division would be rejected.
D)The discount rate used to evaluate projects submitted by the gourmet coffee shop division would be too low.

Question

Quizplus · Accepted Answer

Given that the gourmet coffee shop division (Javabean) has a lower market-beta (1.25) compared to Boutique's overall market-beta (1.60), using Boutique's overall cost of capital to evaluate projects in the gourmet coffee shop division would result in a higher discount rate than what would be appropriate for the lower risk profile of the coffee shop division. This mismatch could lead to potentially good projects being rejected because they might not meet the higher return threshold set by the overall cost of capital, which is influenced more by the bookstore operation's higher risk.

Boutique Booksellers Is Considering Expanding Each of Its Five Shops