Suppose your firm has decided to use a divisional WACC approach to analyze proje

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 0.7, 1.4, 1.5, and 1.7, respectively. Assume all current and future projects will be financed with 25 percent debt and 75 percent equity, the current cost of equity (based on an average firm beta of 1.2 and a current risk-free rate of 7 percent) is 12 percent and the after-tax yield on the company’s bonds is 12 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 0.7, 1.4, 1.5, and 1.7, respectively. Assume all current and future projects will be financed with 25 percent debt and 75 percent equity, the current cost of equity (based on an average firm beta of 1.2 and a current risk-free rate of 7 percent) is 12 percent and the after-tax yield on the company’s bonds is 12 percent.

Explanation / Answer

Answer

iE = if + bE [ E ( iM ) - if]

12% = 7% + 1.2(E ( iM ) -7%)

4.16+7 = E ( iM )

11.16% = E ( iM )

For divison A : iE = if + bE [ E ( iM ) - if] =7%+0.7(11.16% -7%)=9.91 %

For divison B : iE = if + bE [ E ( iM ) - if] =7%+1.4(11.16% -7%)=12.82%

For divison C : iE = if + bE [ E ( iM ) - if] =7%+1.5(11.16% -7%)=13.24%

For divison D : iE = if + bE [ E ( iM ) - if] =7%+1.7(11.16% -7%)=14.07%

Finally, we can solve for the divisional WACCs using equation

For divison A :WACC: = 0.75 * 9.91% +0.25 * 12% =10.43%

For divison B :WACC: = 0.75 * 12.82% +0.25 * 12% =12.61%

For divison C :WACC: = 0.75 * 13.24% +0.25 * 12% =12.93%

For divison D :WACC: = 0.75 * 14.07% +0.25 * 12% =13.55%

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