Suppose your firm has decided to use a divisional WACC approach to analyze proje

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 0.8, 1.2, 1.4, and 1.6, respectively. Assume all current and future projects will be financed with 25 percent debt and 75 percent equity, the current cost of equity (based on an average firm beta of 1.1 and a current risk-free rate of 5 percent) is 12 percent and the after-tax yield on the company

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 0.8, 1.2, 1.4, and 1.6, respectively. Assume all current and future projects will be financed with 25 percent debt and 75 percent equity, the current cost of equity (based on an average firm beta of 1.1 and a current risk-free rate of 5 percent) is 12 percent and the after-tax yield on the company

Explanation / Answer

Cost of equity for firm = 12% = risk free rate+beta*(market return-risk free rate) = 5%+1.1*(market return-5%)

Solving, we get market return = 11.36%

Cost of equity for A = 5%+0.8*(11.36%-5%) = 10.091%

WACC for A = 0.25*10% + 0.75*10.091% = 10.07%

Cost of equity for B = 5%+1.2*(11.36%-5%) = 12.636%

WACC for B = 0.25*10% + 0.75*12.636% = 11.98%

Cost of equity for C = 5%+1.4*(11.36%-5%) = 13.909%

WACC for C = 0.25*10% + 0.75*13.909% = 12.93%

Cost of equity for D = 5%+1.6*(11.36%-5%) = 15.182%

WACC for D = 0.25*10% + 0.75*15.182% = 13.89%

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