Al\'s Enterprises has three divisions: A, B, and C. Division A has the least ris

Question

Al's Enterprises has three divisions: A, B, and C. Division A has the least risk and division C has the most risk. The firm has an aftertax cost of debt of 5.1 percent and a cost of equity of 11.2 percent. The firm is financed with 45 percent debt and 55 percent equity. Management has told the manager of division A that projects in his division will be assigned a discount rate that is 2 percent less than the firm's weighted average cost of capital. What is the discount rate applicable to division A?

Explanation / Answer

Debt @ 5.1% x 45% = 2.295%. Equity @11.2% x 55% = 6.16%. WACC = 8.46% minus 2% = 6.46%. Answer is 6.46%

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