Division Asset Beta Next Period\'s Expected Free Cash Flow ($mm) Expected Growth

Question

Division

Asset

Beta

Next Period's Expected Free Cash

Flow ($mm)

Expected

Growth

Rate

Oil Exploration

1.4

450

4.0%

Oil Refining

1.1

525

2.5%

Gas and Convenience Stores

0.8

600

3.0%

The risk-free rate of interest is 3% and the market risk premium is 5%.

1) Which is the cost of capital for the oil exploration division closest to?

A) 6.0%

B) 7.0%

C) 8.5%

D) 10.0%

Division

Asset

Beta

Next Period's Expected Free Cash

Flow ($mm)

Expected

Growth

Rate

Oil Exploration

1.4

450

4.0%

Oil Refining

1.1

525

2.5%

Gas and Convenience Stores

0.8

600

3.0%

Explanation / Answer

cost of capital = riskfree rate + beta * market risk premium

= 3% + 1.4 * 5%

= 10%

D is the answer

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