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Groceries, Inc. is specialized in the distribution of groceries. NS Groceries is considering expanding into a new line of business by adding coffee shops (the coffee venture) to its existing groceries retail locations. Currently, NS Groceries has a before tax cost of debt of 6% and an effective tax rate of 40%. Its stock has twice as much systematic risk as the market portfolio, and the firm's debt to equity ratio is 0.5. The firm has identified a pure play company (NS Coffee, Inc.) whose only business is operating coffee shops. NS Coffee has a before tax cost of debt of 8%, a beta of 2.5, and a debt to equity 2 ratio of 0.2. The effective tax rate of NS Coffee is 20%. The expected return on the market is 8%, and the risk free rate of interest is 2%.
a) Determine the appropriate discount rate (WACC) NS Groceries should use for evaluating new projects within its business of groceries distribution.
b) Determine the appropriate discount rate (WACC) NS Groceries should use for evaluating the new coffee venture if the new venture will have a debt to equity ratio similar to that of NS Groceries.
c) What are the potential implications for the capital budgeting decision of the new venture if NS Groceries uses the WACC of its groceries distribution to evaluate this new venture? Briefly explain.
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