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%