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  1. Grand Enterprises is an all-equity firm with two divisions: office equipment and packaging. The office equipment division accounts for 70% of the firm’s market value and the packaging division accounts for 30% of the firm’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 Grand’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).

  1. Is project A on, above, or below the Security Market Line (SML)? Briefly motivate your answer.

  2. Is project B on, above, or below the Security Market Line (SML)? Briefly motivate your answer.

  3. Should Grand invest in project A? Should Grand invest in project B? Briefly motivate your answer.

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