Question

Colt Manufacturing has two​ divisions: 1)​ pistols; and​ 2) rifles. Betas for the two divisions have been determined to be beta

​(pistol)equals=0.7 and beta (rifle)equals=1.3 The current​ risk-free rate of return is 1.5%, and the expected market rate of return is 5.5 %. The​ after-tax cost of debt for Colt is 7%. The pistol​ division's financial proportions are 32.5​% debt and 67.5​% equity, and the rifle​ division's are 42.5​% debt and 57.5​% equity.

a. What is the pistol​ division's WACC?

b.  What is the rifle​ division's WACC?

Answer 1

Given about colt manufacturing,

Beta of pistol division Bp = 0.7

Beta of Rifle division Br = 1.3

Risk free rate Rf = 1.5%

expected market rate of return Rm = 5.5%

a). Using CAPM, expected return on Pistol division is

Ke = Rf + Bp*(Rm-Rf) = 1.5 + 0.7*(5.5-1.5) = 4.3%

after-tax cost of debt Kd*(1-T) = 7%

The pistol​ division's financial proportions are

Weight of debt Wd = 32.5%

Weight of equity We = 67.5%

So, WACC of pistol division = Wd*Kd*(1-T) + We*Ke = 0.325*7 + 0.675*4.3 = 5.18%

b). Using CAPM, expected return on rifle division is

Ke = Rf + Br*(Rm-Rf) = 1.5 + 1.3*(5.5-1.5) = 6.7%

after-tax cost of debt Kd*(1-T) = 7%

The pistol​ division's financial proportions are

Weight of debt Wd = 42.5%

Weight of equity We = 57.5%

So, WACC of rifle division = Wd*Kd*(1-T) + We*Ke = 0.425*7 + 0.575*6.7 = 6.83%