Suppose your firm has decided to use a divisional WACC approach to analyze proje
ID: 2795264 • 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.)
What will the WACCs be for each division? (Do not round intermediate calculations and round your final answers to 2 decimal places.)
Explanation / Answer
CAPM or equity beta = Risk free rate (Rf) + market risk premium * beta
14% = 7% + 1.3 * market risk premium
Therefore, market risk premium = 7% / 1.3 = 5.38%
For A, cost of equity = 7 + 0.9*5.38 = 11.84%
For B, cost of equity = 7 + 1.3*5.38 = 13%
For C, cost of equity = 7 + 1.4*5.38 = 14.53%
For D, cost of equity = 7 + 1.5*5.38 = 15.07%
WACC for all the divisions: weight for cost of debt * debt percentage + weight for cost of equity * equity percentage
WACC for A = 0.30 * 12% + 0.70 * 11.84% = 11.89%
WACC for B = 0.30 * 12% + 0.70 * 13% = 12.7%
WACC for C = 0.30 * 12% + 0.70 * 14.53% = 13.77%
WACC for D = 0.30 * 12% + 0.70 * 15.07% = 14.15%
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