Question

Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.5, 1.0, 1.2, and 1.5, respectively. Assume all current and future projects will be financed with 50 debt and 50 equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 8 percent) is 13 percent and the after-tax yield on the company’s bonds is 9 percent.

What will the WACCs be for each division? (Round your answers to 2 decimal places.)

	WACCs
Division A	%
Division B	%
Division C	%
Division D	%

Answer 1

Answer :

We are given that,

Cost of equity based on average beta of 1 = 13%

Risk premium = Cost of equity - Risk free rate = 13% - 8% = 5%

Market premium = Risk premium / Beta = 5% / 1 = 5%

Division	Risk-free Rate	Market Premium	Beta	Risk Premium ( Market premium * Beta )	Cost of equity ( Risk-free rate + Risk premium )
A	8%	5%	0.5	2.50%	10.50%
B	8%	5%	1.0	5.00%	13.00%
C	8%	5%	1.2	6.00%	14.00%
D	8%	5%	1.5	7.50%	15.50%

Calculation of WACC :

Division	Weight of equity	Cost of equity	Weighted cost of Equity ( Weight of equity * Cost of equity )	Weight of debt	Cost of Debt	Weighted cost of debt ( Weight of debt * cost of debt )	WACC ( Weighted cost of equity + Weighted cost of debt )
A	0.50	10.50%	5.25%	0.50	9%	4.50%	9.75%
B	0.50	13.00%	6.50%	0.50	9%	4.50%	11.00%
C	0.50	14.00%	7.00%	0.50	9%	4.50%	11.50%
D	0.50	15.50%	7.75%	0.50	9%	4.50%	12.25%