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 0.6, 1.0, 1.3, and 1.6, respectively. Assume all current and future projects will be financed with 55 debt and 45 equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 3 percent) is 14 percent and the after-tax yield on the company’s bonds is 8 percent.

What will the WACCs be for each division? (rounded to 2 decimal places)

Answer 1

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Answer:

Firm's cost of equity = risk free rate + beta * market risk premium

So 14% = 3% + 1.0 * market risk premium

Solving, we get market risk premium = 11%

Cost of equity for A = 3% + 0.6*11% = 9.6%

Cost of equity for B = 3% + 1.0*11% = 14%

Cost of equity for C = 3% + 1.3*11% = 17.3%

Cost of equity for D = 3% + 1.6*11% = 20.6%

Now, we can calculate the respective WACC's.

WACC for A = 0.55 * 8% + 0.45 * 9.6% = 8.72%

WACC for B = 0.55 * 8% + 0.45 * 14% = 10.7%

WACC for C = 0.55 * 8% + 0.45 * 17.3% = 12.19%

WACC for D = 0.55 * 8% + 0.45 * 20.6% = 13.67%