ABC, Inc., has three divisions: A, B, and C. Division A has the least risk and d
ID: 2781764 • Letter: A
Question
ABC, Inc., has three divisions: A, B, and C. Division A has the least risk and division C has the most risk. ABC has an aftertax cost of debt of 4.6% and a cost of equity of 9.5%. The firm is financed with 50% debt and 50% equity. Management has told the divisional manager of division A that projects in that division are assigned a discount rate that is 1% less than the firm's weighted average cost of capital. What is the discount rate applicable to division A?
6.65%
6.05%
7.05%
6.31%
7.18%
a.6.65%
b.6.05%
c.7.05%
d.6.31%
e.7.18%
Explanation / Answer
WACC = rD (1- Tc )*( D / V )+ rE *( E / V )
Where...
rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)
WACC = 0.5*4.6% + 0.5*9.5% = 7.05%
Discount rate = WACC - discount = 7.05% - 1% = 6.05%
Option B.
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