Back to Assignment Attempts: Keep the Highest: 14 9. Adjusting the cost of capit

Question

Back to Assignment Attempts: Keep the Highest: 14 9. Adjusting the cost of capital for risk Aa Aa 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 1.8, because it will have more risk than the firm's wholesale division. The retail division is expected to have a beta of 0.5, 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 6.1%. Based on this information, fill in the missing information in the following below: Cost of Capital Wholesale division Marketing division Retail division If 70% of Newtown Propane's total value ends up in the wholesale division, 20% in the marketing division, and 10% in the retail division, then its investors should require a return of 13.13% 14.68% 11.83% 16.58%

Explanation / Answer

As per CAPM

required return=risk free+beta*market risk premium

Hence,

Wholesale Division's cost of capital=4.2+1.2*6.1=11.52%

Marketing Division's cost of capital=4.2+1.8*6.1=15.18%

Retail Division's cost of capital=4.2+0.5*6.1=7.25%

Return=70%*wholesale return+20%*marketing return+10%*retail return

=70%*11.52%+20%*15.18%+10%*7.25%

=11.83%

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