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DUR Inc. has two distinctive business divisions, i.e. fitness centers and travel agency. The fitness center...

DUR Inc. has two distinctive business divisions, i.e. fitness centers and travel agency. The fitness center business has a cost of capital of 10% and the travel agency business has a cost of capital of 7%. The weighted average cost of capital of the company is 10%. DUR has more than 80% of its revenues from its fitness center business, and the rest from the travel agency business. DUR is considering a purchase of another company in the travel agency business. What is the appropriate cost of capital to evaluate the new acquisition? Explain.

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Answer #1

The appropriate cost of capital to evaluate the new acquisition is 7%.

The cost of capital for travel business is 7% for DUR inc. The same needs to used while evaluating new investment. As the travel business will have similar risk and return characteristics therefore the cost of capital for travel business will be used. Also the customer base, operating costs, structure of business will be the same fro travel business . The cost of capital for fitness centre cannot be used as the risk and return characteristics wont be same. Also the cost of capital for DUR will have different debt to equity ratios as compared to the travel business acquisition. Hence the same cannot be used.

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