Question

a. Gentle corporation has two divisions of equal size. Division A has a beta of 0.93, division B has a beta of 1.57. The company has no debt. The cost of capital for the entire corporation is 16%. Which of the two divisions have a lower cost of capital? Explain.

b. Barrack mining uses a cost of capital of 11 % to evaluate an average risk project. It adds or subtracts 3% from its WACC to adjust for risk. Currently the firm has two mutually exclusive projects under consideration. Both the projects have an initial cost of $100,000 and will last 4 years. Project A , riskier than the average will produce an annual cash flow of $72,164 at the end of each year. Project B is less than average risk and will produce cash flows of $145,340 at the end of years 3 and 4 only. Which investment should the firm choose? Explain

Answer 1

a. Division with a high beta, i.e a high degree of risk will have a higher cost of equity (Beta is a measure of risk). Hence Division B would have higher cost of capital.

b. Division a is better has it provides higher PV inflows.

	Division A
Year	Annual inflow	PV factor @ 13.79%	Present value
1	72164	0.87881	63419
2	72164	0.77231	55733
3	72164	0.67872	48979
4	72164	0.59646	43043
			211174
	Division A
Year	Annual inflow	PV factor @ 15.71%	Present value
1	0	0.86423	0
2	0	0.74689	0
3	145340	0.64549	93815
4	145340	0.55785	81078
			174893

cost of capital	=	WACC+ B( Risk cost)
Division A		0.11+(0.93*0.03)
		0.1379
Division A		0.11+(1.57*0.03)
		0.1571