Question

10.   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 0.5, because it will have less risk than the firm’s wholesale division. The risk-free rate is 3.1%, and the market-risk premium is 6.7%. Based on this information, fill in the missing information in the following below:

Cost of Capital
Wholesale division	3.10% 6.82% 11.14% 6.20%
Marketing division	19.67% 18.52% 18.12% 17.17%
Retail division	6.45% 19.12% 19.22% 17.92%

If 55% of Newtown Propane’s total value ends up in the wholesale division, 20% in the marketing division, and 25% in the retail division, then its investors should require a return of (11.21%, 15.96%, 14.06%, or 12.51%)

Answer 1

Marketing Division:

Proportion of Firm Value = M = 0.2 and Beta = B(m) = 2.1

Wholesale Division:

Proportion of Firm Value = W = 0.55 and Beta = B(w) = 1.2

Retail Division:

Proportion of Firm Value = R = 0.25 and Beta = B(r) = 0.5

Weighted Average Firm Beta = B(f) = B(m) x M + B(w) x W + B(r) x R = 0.2 x 2.1 + 0.55 x 1.2 + 0.25 x 0.5 = 1.205

Risk Free Rate = Rf = 3.1 % and Market Risk Premium = Rm = 6.7 %

Hence, Required Rate of Return = Rf + B(f) x Rm = 3.1 + 1.205 x 6.7 = 11.1735 % or approximately 11.21 %