Adjusting the cost of capital for risk Divisional Costs of Capital Newtown Propa

Question

Adjusting the cost of capital for risk Divisional Costs of Capital Newtown Propane currently has only a wholesale division and uses only equity capital; however, it is considering creating marketing and retail divisions. Its beta is currently 1.2. The marketing division is expected to have a beta of 2.1, because it will have more risk than the firm's wholesale division. The retail division is expected to have a beta of 0.8, because it will have less risk than the firm's wholesale division. The risk-free rate is 4.2%, and the market-risk premium is 6.7%. Based on this information, fill in the missing information in the following below: Wholesale division Marketing division Retail division If 65% of Newtown Propane's total value ends up in the wholesale division, 25% in the marketing division, and 10% in the retail division, then its investors should require a return of

Explanation / Answer

The cost of equity is expressed formulaically below:

Re = rf + (rm – rf) *

Where:

Cost of Capital

Wholesale Division = 4.2 + 1.2 * 6.7 = 12.24%

Marketing Division = 4.2 + 2.1 * 6.7 = 18.27%

Retail Division        = 4.2 + 0.8 * 6.7 = 09.56%

Cost of Capital

Wholesale Division

12.24%

Marketing Division

18.27%

Retail Division

09.56%

Return required by investors = 0.65 * 12.24% + 0.25 * 18.27% + 0.10 * 9.56%

                                                     = 13.48%

Cost of Capital

Wholesale Division

12.24%

Marketing Division

18.27%

Retail Division

09.56%

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