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 0.8, 1.0, 1.5, and 1.7, 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 6 percent) is 14 percent and the after-tax yield on the company’s bonds is 7 percent. What will the WACCs be for each division? (Round your answers to 2 decimal places.

Answer 1

The answers are:

A	9.70%
B	10.50%
C	12.50%
D	13.30%

Calculations and explanations:

Average firm beta = 1, current cost of equity = 14% and risk free rate is 6%

Thus as per CAPM: cost of equity = risk free rate + beta*market premium

Or 14% = 6% + 1*market premium

Or market premium = (14%-6%)/1 = 8%

We will now apply CAPM to find the cost of equity of each division as shown below:

Division A = 6% + (0.8*8%) = 12.40%

Division B = 6%+(1*8%) = 14.00%

Division C = 6% + (1.5*8%) = 18.00%

Division D = 6% + (1.7*8%) = 19.60%

Now weighted average cost for each division = 50%*cost of equity + 50%*after tax cost of debt

So WACC for each division is:

A = 0.5*12.40% + 0.5*7% = 9.70%

B = 0.5*14% + 0.5*7% = 10.50%

C = 0.5*18% + 0.5*7% = 12.50%

D = 0.5*19.6% + 0.5*7% = 13.30%