Grand Enterprises is an all-equity firm with two divisions: office equipment and packaging. The office equipment division accounts for 70% of the firmâ€™s market value and the packaging division accounts for 30% of the firmâ€™s market value. The asset beta of firms in the office equipment industry is 1.5 and the asset beta of firms in the packaging industry is 0.9. The risk-free rate is 1.5% and the market risk premium is 5%. Assume that there are no corporate taxes.
a. Estimate Grandâ€™s equity cost of capital.
Grand is currently evaluating two investment opportunities: it has a project called A in the office equipment division and a project called B in the packaging division. Each project requires an investment of $40,000 today, which will be financed entirely with equity.
Project A is expected to generate a cash flow of $2,400 in one year (t=1). The cash flow is then expected to grow at 2.5% per year forever.
Project B is expected to generate a single cash flow of $43,000 in one year (t=1).
Is project A on, above, or below the Security Market Line (SML)? Briefly motivate your answer.
Is project B on, above, or below the Security Market Line (SML)? Briefly motivate your answer.
Should Grand invest in project A? Should Grand invest in project B? Briefly motivate your answer.