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 1.21, the risk-free rate is 4.5%, its market value of equity is $67 billion, and it has $700 million worth of debt with a yield to maturity of 6%. Your tax rate is 35% and you use a market risk premium of 5% in your WACC estimates.

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

b. If your overall company WACC is 12% and the computer sales division represents 40% of the value of your firm, what is an estimate of the WACC for your software division?

Answer 1

a. WACC = weight of debt*cost of debt*(1-tax rate) + weight of equity*cost of equity

weight of debt = market value of debt/(market value of debt + market value of equity)

weight of equity = market value of equity/(market value of debt + market value of equity)

weight of debt = $0.7 billion/($0.7 billion + $67 billion) = $0.7 billion/$67.7 billion = 0.01

weight of equity = $67 billion/($0.7 billion + $67 billion) = $67 billion/$67.7 billion = 0.99

cost of debt is the yield to maturity of debt which is 6%.

cost of equity = risk-free rate + beta*market risk premium = 4.5% + 1.21*5% = 4.5% + 6.05% = 10.55%

WACC = 0.01*6%*(1-0.35) + 0.99*10.55% = 0.01*6%*0.65 + 10.4445% = 0.039% + 10.4445% = 10.48%

10.48% is an estimate of the WACC for your computer sales division.

b. estimate of the WACC for software division = Firm's overall WACC*representation of % of value of the firm

% of software division of value of the firm = 1 - % of sales division of value of the firm = 1 - 0.40 = 0.60

estimate of the WACC for software division = 12%*0.60 = 7.2%

7.2% is an estimate of the WACC for your software division.