9. Adjusting the cost of capital for risk Aa Aa Divisional Costs of Capital Newt

Question

9. Adjusting the cost of capital for risk Aa Aa Divisional Costs of Capital Newtown Propane currently has only a wholesale division and uses only equity capital; however, it is considering creating marketing and retail divisions. Its beta is currently 1.1. The marketing division is expected to have a beta of 2.0, because it will have more risk than the firm's wholesale division. The retail division is expected to have a beta of 0.8, because it will have less risk than the firm's wholesale division. The risk-free rate is 4.2%, and the market-risk premium is 5.2%. Based on this information, fill in the missing information in the following below: Cost of Capital Wholesale division Marketing division Retail division If 70% of Newtown Propane's total value ends up in the wholesale division, 20% in the marketing division, and 10% in the retail division, then its investors should require a return of

Explanation / Answer

Ans. Calculation of cost of capital

Wholesale division Ke = 4.2+ (5.2)X1.1 =9.92%

Marketing division ke = 4.2+ (5.2)X2 =14.60%

Retail Division Ke = 4.2+(5.2)X.80 = 8.36%

Weight in Whole division is 70% and Weight in Marketing division is 20% and Weight in Retail 10%

Required Rate of Return = 9.92X.70+14.60X.20+8.36X.10 = 6.944+2.92+.836 =10.70%

Formula for calculation of cost of capital

Ke = Rf+ (Market return-Risk free)Xbeta

Market risk premium = Market return-Risk free Return

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