Suppose your firm has decided to use a divisional WACC approach to analyze proje
ID: 2740745 • 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 0.9, 1.3, 1.4, and 1.5, 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 7 percent) is 14 percent and the after-tax yield on the company’s bonds is 12 percent.
What will the WACCs be for each division? (Do not round intermediate calculations and round your final answers to 2 decimal places.)
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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 0.9, 1.3, 1.4, and 1.5, 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 7 percent) is 14 percent and the after-tax yield on the company’s bonds is 12 percent.
Explanation / Answer
weighted-average cost of capital (WACC)
Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its Share holders and debt holders .
It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components.
Here, cost of debt is to be adjusted with tax because interest on debt is tax deductible but not in case of equity as dividend is not tax deductible item.
Formula WACC =Ke*Weight of equity in capital structure +Kd(1-t)**Weight of debt in capital structure
In the given problem, Cost debt is given i,e, after tax debt 12% but cost of equity for ecah division not given so compute cost of equity for each division as per CAPM model
cost of equity as per CAPM model =Rf +beta(Rm -Rf) , Where, Rf = Risk free, Rm =Return on market,
here, market return is not given, Compute it as per CAPM model,
Ke =Rf+Beta of project (Rm-Rf)
14% =7%+1.3(Rm-7%)
Rm-7% =(14%-7%)/1.3
Rm =5.38%+7% =12.38%
Compuation of Cost of equity of Each Division
Now compute WACC of Each Division
Division Rf beta Rm Rf+beta(Rm-Rf) A 7% 0.9 12.38% 11.84% B 7% 1.3 12.38% 13.99% C 7% 1.4 12.38% 14.53% D 7% 1.5 12.38% 15.07%Related Questions
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