Question

9. Adjusting the cost of capital for risk

Divisional Costs of Capital

A firm’s cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions:

Wizard Co. currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions. Its beta is currently 1.1. The risk-free rate is 2.8%, and the market risk premium is 6.7%.

This means that the firm’s real estate division will have a cost of capital of:

5.88%

5.60%

10.17%

2.52%

The consulting division is expected to have a beta of 2.0, because it will be riskier than the firm’s real estate division.

This means that the firm’s consulting division will have a cost of capital of:

17.55%

16.20%

17.15%

18.70%

The distribution division will have less risk than the firm’s real estate division, so its beta is expected to be 0.8.

This means that the distribution division’s cost of capital will be:

16.95%

18.25%

8.16%

18.15%

Wizard Co. expects 70% of its total value to end up in the real estate division, 20% in the consulting division, and 10% in the distribution division.

Based on this information, what rate of return should its investors require once it opens the new divisions? (Note: Round your intermediate calculations to two decimal places.)

15.93%

14.03%

12.48%

11.18%

Answer 1