Estimate the divisional cost of capital for each Southeastern division assuming

Question

Estimate the divisional cost of capital for each Southeastern division assuming that both divisions have the same optimal (target) capital structure. (Hint: Use the CAPM to produce a cost of equity for each division, and assume the same corporate tax rate and debt cost for each division.)

expected rate of return of the market:   

expected rate of return of the S&P 500 Index = 11.0%   

Required rate of return of long term debt on average company   

Yield to maturity on A-rated long term debt for a company with beta of 1.0 = 7.0%

Current yield curve on US Treasury Securities

Term of maturity    Yield   

3months 2.5%

6 months    3.0

9 months    3.0   

1 year    3.5   

5 year    4.0   

10 years    4.5   

15 years    4.8

20 years    5.0

25 years    5.1

30 years    5.2

Explanation / Answer

Cost of Equity can be calculated using CAPM model as follows -

Ke = Risk free return + (Market Return - Risk free return ) x Beta

Considering the Long term required rate of return of the company, US Treasury yield of 10 years , that is 4.5% p.a is used for calculation. because the Beta of the company is 1, the risk free return will not affect the cost of equity.

Beta as mentioned in the question = 1

Therefore, Ke = 4.5 + (11 - 4.5) x 1 = 11 % p. a

Tax rate is not mentioned in the question , it is assumed as 30 %

Therefore, Cost of Debt = 7 % x (1 - tax rate) = 4.9% p. a

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