Question

Your company has two​ divisions: One division sells software and the other division sells computers through a direct sales​ channel, primarily taking orders over the internet. You have decided that Dell Computer is very similar to your computer​ division, in terms of both risk and financing. You go online and find the following​ information: Dell's beta is 1.15​, the​ risk-free rate is 4.1%​, its market value of equity is $65.9 ​billion, and it has $704 million worth of debt with a yield to maturity of 6.4%. Your tax rate is 35% and you use a market risk premium of 5.6% in your WACC estimates.

a. What is an estimate of the WACC for your computer sales​ division?

b. If your overall company WACC is 11.1% and the computer sales division represents 43% of the value of your​ firm, what is an estimate of the WACC for your software​ division? ​Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

Market value of firm = $704 million + $61.9 million = $765.9 million

Weight of debt = $704 million / $765.9 million

= 0.9192

Weight of equity = $61.9  million / $765.9 million

   = 0.0808

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke= Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

b= stock’s beta

Ke= 4.1% + 1.15*5.6%

= 4.1% + 7.4060%

= 11.5060%.

WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.9192*6.4%*(1 - 0.35) + 0.0808*11.5060%

= 0.9192*4.16% + 0.0808*11.5060%

= 3.8239% + 0.9297%

= 4.7536% 4.75%

b.Overall company WACC = Weight of computer sales division + WACC of computer sales division + Weight of software division*WACC of software division

11.1% = 0.43*4.75% + (1 - 0.43)*WACC of software division

11.1% = 2.0425% + 0.57*WACC of software division

0.57*WACC of software division = 11.1% - 2.0425%

WACC of software division = 9.0575% / 0.57

= 15.8904% 15.89%.

In case of any query, kindly comment on the solution.