uppose your firm has decided to use a divisional WACC approach to analyze projec
ID: 2754441 • Letter: U
Question
uppose 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 0.7, 1.0, 1.4, and 1.6, respectively. Assume all current and future projects will be financed with half debt and half equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 3 percent) is 12 percent and the after-tax yield on the company’s bonds is 10 percent.
What will the WACCs be for each division?
Explanation / Answer
A B C D Firm Beta 1 1 1 1 Project Beta 0.7 1 1.4 1.6 Debt-Equity Ratio 1:1 1:1 1:1 1:1 Risk free rate of return 3% 3% 3% 3% Cost of equity 12% 12% 12% 12% Cost of debt (after tax) 10% 10% 10% 10% Return on equity [Rf + (Rm - Rf)*Beta] Here, Rf is risk free rate of return Rm is the cost of equity for the firm as a whole Beta is the project beta 9% 12% 16% 17% WACC (Weight of debt * Cost of Debt) + (Weight of Equity * Return on Equity) 10% 11% 13% 14%
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