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, 1.1, 1.5, and 1.7, 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 4 percent) is 13 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, 1.1, 1.5, and 1.7, 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 4 percent) is 13 percent and the after-tax yield on the company

Explanation / Answer

To calculate the WACC, we need to calculate the cost of equity and after tax cost of debt. The cost of equity for each division will be calculated with the use of CAPM model. The formula for calculating cost of equity is:

CAPM = Risk Free Rate + Beta*(Market Risk Premium)

We will also have to calculate the market risk premium, since we have not been provided with the market rate of return. For this, we will have to use the information provided in the question on risk free rate, current cost of equity and beta.

The formula for calculating WACC is:

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Equity*Weight of Equity

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Step 1: Calculate Market Risk Premium

Here, Cost of Equity = 13%, Risk Free Rate = 4% and Beta = 1.3.

Using these values in the above formula, we get,

13 = 4 + 1.3*Market Risk Premium

Market Risk Premium = (13 - 4)/1.3 = 6.92%

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Step 2: Calculate Cost of Equity for Each Division

Using the values provided in the question and market risk premium calculated in step 1, we get

Division A = 4 + .8*6.92 = 9.54%

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Division B = 4 + 1.1*6.92 = 11.61%

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Division C = 4 + 1.5*6.92 = 14.38%

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Division D = 4 + 1.7*6.92 = 15.76%

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Step 2: Calculate WACC for Each Division

Weight of Debt = 30% and Weight of Equity = 70%

Using the values provided in the question and formula for WACC we get,

WACC (Division A) = 30%*9% + 70%*9.54% = 9.38%

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WACC (Division B) = 30%*9% + 70%*11.61% = 10.83%

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WACC (Division C) = 30%*9% + 70%*14.38% = 12.77%

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WACC (Division D) = 30%*9% + 70%*15.76% = 13.73%

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