Suppose your firm has decided to use a divisional WACC approach to analyze proje
ID: 2739933 • Letter: S
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 20 percent debt and 80 percent equity, the current cost of equity (based on an average firm beta of 1.3 and a current risk-free rate of 5 percent) is 14 percent and the after-tax yield on the company’s bonds is 10 percent.
What will the WACCs be for each division? (Do not round intermediate calculations and round your final answers to 2 decimal places.)
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 20 percent debt and 80 percent equity, the current cost of equity (based on an average firm beta of 1.3 and a current risk-free rate of 5 percent) is 14 percent and the after-tax yield on the company’s bonds is 10 percent.
Explanation / Answer
Answer
Step 1:
Find the market risk premium.
14% = 5% + 1.3(MRP);
= > MRP = 6.92%.
Step 2:
Find the cost of equity for each division using CAPM;
A:
6.92 + .8 * 6.92
= 12.45%;
B:
14%;
C:
17.3%;
D:
18.68%
Calculation for the above answer
MRp
Avg
Beta
A
6.92
0.8
5.536
12.456
B
6.92
1.1
7.612
14.532
C
6.92
1.5
10.38
17.3
D
6.92
1.7
11.764
18.684
; Step 3:
Find the WAACs for each division
; A:
.8(12.46%) + .8(8%)
= 10.04%;
B
:16.10%;
C:
26.1%;
D:
31.93%
Calculaion for the above answer
(A)
Avg
Beta
(B)
( C ) =
(A*B)
Company
Bond rate
D
E=D*B
F
A
12.456
0.8
9.9648
10%
0.08
10.0448
B
14.532
1.1
15.9852
10%
0.11
16.0952
C
17.3
1.5
25.95
10%
0.15
26.1
D
18.684
1.7
31.7628
10%
0.17
31.9328
MRp
Avg
Beta
A
6.92
0.8
5.536
12.456
B
6.92
1.1
7.612
14.532
C
6.92
1.5
10.38
17.3
D
6.92
1.7
11.764
18.684
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