Suppose your firm has decided to use a divisional WACC approach to analyze proje
ID: 2635279 • Letter: S
Question
Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.55, 0.9, 1.2, and 1.5, respectively. If all current and future projects will be financed with half debt and half equity, and if the current cost of equity (based on an average firm beta of 1 and a current risk-free rate of 6.8 percent) is 13.7 percent and the after-tax yield on the company's bonds is 10.3 percent.
What will the WACCs be for each division?
Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.55, 0.9, 1.2, and 1.5, respectively. If all current and future projects will be financed with half debt and half equity, and if the current cost of equity (based on an average firm beta of 1 and a current risk-free rate of 6.8 percent) is 13.7 percent and the after-tax yield on the company's bonds is 10.3 percent.
Explanation / Answer
Cost of equity = Average beta*Market Risk Premium + Risk free rate
13.7%= Average beta*Market Risk Premium +6.8%
Average beta =1.0375(0.55+0.9+1.2+1.5/4)
1.0375*Market Risk Premium = 13.7%-6.8% =6.9%
Market Risk Premium =6.9%/1.0375 = 0.066506024
Firm
Average beta
D/(D+E)
E/(D+E)
Market risk premium
cost of equity=
Rf+ Beta*Market risk premium
After tax Cost of debt
WACC
A
0.55
0.5
0.5
0.06650602
0.104578313
0.103
0.103789
B
0.9
0.5
0.5
0.06650602
0.127855422
0.103
0.115428
C
1.2
0.5
0.5
0.06650602
0.147807229
0.103
0.125404
D
1.5
0.5
0.5
0.06650602
0.167759036
0.103
0.13538
Firm
Average beta
D/(D+E)
E/(D+E)
Market risk premium
cost of equity=
Rf+ Beta*Market risk premium
After tax Cost of debt
WACC
A
0.55
0.5
0.5
0.06650602
0.104578313
0.103
0.103789
B
0.9
0.5
0.5
0.06650602
0.127855422
0.103
0.115428
C
1.2
0.5
0.5
0.06650602
0.147807229
0.103
0.125404
D
1.5
0.5
0.5
0.06650602
0.167759036
0.103
0.13538
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