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 |

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