9. Adjusting the cost of capital for risk AaAa Divisional Costs of Capital A fir
ID: 2780580 • Letter: 9
Question
9. Adjusting the cost of capital for risk AaAa Divisional Costs of Capital A firm's cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions: Wizard C0·currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions, its beta is currently 1.3. The risk-free rate is 4.4%, and the market-risk premium is s 10.12% O 11.94% 8.30% O 4.40% This means that the firm's real estate division will have a cost of capital of: The consulting division is expected to have a beta of 1.8, because it will be riskier than the firm's real estate division. 15.79% 17.34% O 16.19% 0 14.84% This means that the firm's consulting division will have a cost of capital of:Explanation / Answer
As it is complety equity firm, cost of capital = cost of equity
in CAPM model
cost of equity = risk free rate + beta * market risk premium
risk free rate = 4.4%
market risk premium = 5.8%
1)
beta = 1.3
cost of equity = 4.4 % + 1.3*5.8% = 11.94%
2)
beta = 1.8
cost of equity = 4.4 % + 1.8*5.8% = 14.84%
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