Question

Suppose Conglomerate company has three divisions of equal size: An automotive retailer division with a beta of 2, a computer hard drive manufacturing division with a beta of 1.3, and an electric utility division with a beta of 0.6. If the manager of the firm decides to use one discount rate (i.e., to use the firm’s overall cost of capital) to evaluate all its projects, what will happen to the firm’s risk and share price in the long run?

a) The firm’s risk will decrease; stock price will increase;
b) There will be no change in firm’s risk and stock price will increase as long as they choose positive NPV project even if using one discount rate;
c) The firm’s risk will decrease; stock price will decrease;
d) The firm’s risk will increase; stock price will increase;
e) The firm’s risk will increase; stock price will decrease;

Answer 1

Using a single discount rate for projects with differing risk profiles may lead to increased firm risk and potential decrease in share price due to risk evaluation distortions.

Step-by-step explanation:

When a conglomerate company with three divisions of equal size, each with a different beta, uses one discount rate to evaluate all its projects, it affects the firm's risk and share price. Specifically, a conglomerate like this with an automotive retailer division (beta of 2), a computer hard drive manufacturing division (beta of 1.3), and an electric utility division (beta of 0.6) that uses a single discount rate might not accurately reflect the risk associated with each division. Using a too-high discount rate for low-risk projects may lead to undervaluation and missed investment opportunities, and using a too-low rate for high-risk projects may result in overvaluation and poor investment decisions.

Choosing one cost of capital across all divisions may distort the project selection process, favoring riskier projects and possibly leading to an inconsistent risk profile, which could actually increase the firm's overall risk rather than decrease it. In the long run, if the company consistently chooses projects that do not accurately compensate for their risk, the share price could decrease as the market adjusts for the actual risk profile of the company's investments. Therefore, the correct answer is that the firm's risk will likely increase and the share price may decrease, option (e).