Suppose your firm has decided to use a divisional WACC approach to analyze proje
ID: 2740715 • 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 0.9, 1.3, 1.4, and 1.5, respectively. Assume all current and future projects will be financed with 30 percent debt and 70 percent equity, the current cost of equity (based on an average firm beta of 1.3 and a current risk-free rate of 7 percent) is 14 percent and the after-tax yield on the company’s bonds is 12 percent.
What will the WACCs be for each division? (Do not round intermediate calculations and round your final answers to 2 decimal places.)
PLEASE SHOW WORK,
THANKS!
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 0.9, 1.3, 1.4, and 1.5, respectively. Assume all current and future projects will be financed with 30 percent debt and 70 percent equity, the current cost of equity (based on an average firm beta of 1.3 and a current risk-free rate of 7 percent) is 14 percent and the after-tax yield on the company’s bonds is 12 percent.
Explanation / Answer
Firms Weighted Average cost of capital:
Ratio of Debt : Equity is 30:70
Risk Free rate of return is 7%
Current cost of equity is 14%
Company bonds rate of interest is 12%
Weighted average cost of capital = Cost of equity * Equity weightage + Cost of Debt * Debt wieghtage
= 14% * 0.70 + 12% * 0.30
= 9.8% + 3.60%
= 13.40%
WACC with Beta = Risk Free rate of return + Beta *(Cost of capital - Risk free rate of return)
WACC of Division:
Division A = 7% + 0.9*(13.40% - 7%) = 12.76%
Division B = 7% + 1.3*(13.40% - 7%) = 15.32%
Division C = 7% + 1.4*(13.40% - 7%) = 15.96%
Division D = 7% + 1.5*(13.40% - 7%) = 16.60%
Note: Beta increase means high risk compensated with higher rate of return
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