Question

Sigma Investment Ltd (SIL) is a provider of computer software and information technology services in two large regions of South East Asia, where its two divisions are located. The company uses a market rate of 11% to evaluate investments; however, based on recent management reports, it realized that the two divisions have a quite different risk and return profiles. In fact, comparable companies for division 1 have equity betas of 1.5 while for companies in division 2 it is about 0.5. The financial manager aims to estimate the cost of capital as precisely as possible and tries to evaluate how acceptable investments in both divisions are at an 11 percent rate.

The following data is available for both divisions:

	Division 1 (%)	Division 2 (%)
Equity beta	1.5	0.5
Tax rate	30	30
Cost of debt	6	11
Debt ratio	25	45
The risk-free rate of interest for both divisions	4.5
The market risk premium for both divisions	6

1. Estimate the weighted average cost of capital (WACC) for both divisions.
2. Are both these divisions being a viable investment? Why and why not?

Answer 1