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
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.
|Year||Annual inflow||PV factor @ 13.79%||Present value|
|Year||Annual inflow||PV factor @ 15.71%||Present value|
|cost of capital||=||WACC+ B( Risk cost)|
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