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 1.22, the risk-free rate is 4.7%, its market value of equity is $65.6 billion, and it has $694 million worth of debt with a yield to maturity of 6.1%. Your tax rate is 35% and you use a market risk premium of 5.5% in your WACC estimates. a. What is an estimate of the WACC for your computer sales division? b. If your overall company WACC is 12.7% and the computer sales division represents 37% of the value of your firm, what is an estimate of the WACC for your software division? Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer #1

Since our computer dividion is similar to Dell, we will use WACC of Dell as WACC for our computer division

WACC = Cost of Equity*Weight of Equity + Cost of Debt*(1-tax)*Weight of Debt

Cost of Equity = Rf + * MArket Risk Premium = 4.7% + 1.22*5.5% = 11.41%

Weight of equity = Equity / (Debt+Equity) = 65600 / (694+65600) = 0.989531

Weight of Debt = Debt / (Debt+Equity) = 694 / (694+65600) = 0.010469

WACC = Cost of Equity*Weight of Equity + Cost of Debt*(1-tax)*Weight of Debt

WACC = 11.41% * 0.989531 + 6.1% *(1-35%)*0.010469 = 11.3321%

b) If overall WACC is 12.7% and Computer sales is 37% of firm value

Firm WACC is weigheted average of division WACC

Firm WACC = Weight of Computer division*Computer division WACC + Weight of Software division*Softwaredivision WACC

12.7% = 37%*11.3321% + (1-37%)*Software WACC

12.7% - 37%*11.3321% = 0.63*Software WACC

Software WACC = 13.5034%

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