Question

Your company has two? divisions: One division sells software and the other division sells computers through a direct sales? channel, primarily taking orders over the internet. You have decided that Dell Computer is very similar to your computer? division, in terms of both risk and financing. You go online and find the following? information: Dell's beta is 1.16, the? risk-free rate is 4.4%?, its market value of equity is $65.8 billion, and it has $699 million worth of debt with a yield to maturity of 5.8%. Your tax rate is 35%and you use a market risk premium of 5.3% in your WACC estimates.

a. What is an estimate of the WACC for your computer sales? division?

b. If your overall company WACC is 12.3% and the computer sales division represents 37% of the value of your? firm, what is an estimate of the WACC for your software? division?

Answer 1

a

When the risk as well financing of Dell is equal to computer division of our company, we can use its WACC as a proxy for our division's WACC.

Cost of debt at Dell = Pre-tax Cost * (1 - Tax Rate) = 5.8% * (1 - 35%) = 3.77%

Weight of debt = 699/(699 +65800) = 1.05%

Cost of Equity at Dell = R_f + Beta * Market Risk Premium = 4.4% + 1.16 * 5.3% = 10.55%

Weight of Equity = 65800/(699+65800) = 98.95%

WACC = (1.05% * 3.77%) + (98.95% * 10.55%) = 0.04% + 10.44% = 10.48%

b

WACC for overall firm is also weighted (by value) average of two divisions of firm.

WACC for firm = WACC for Computer Sales Division * % of value of Computer Sales Division + WACC for Software Sales Division * % of value of Software Sales Division

12.3% = (10.48% * 37%) + (WACC for SW Sales division * 63%)

WACC for SW division = 13.37%