Question

Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.5, 1.0, 1.2, and 1.5, respectively. Assume all current and future projects will be financed with 50 debt and 50 equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 7 percent) is 14 percent and the after-tax yield on the company’s bonds is 9 percent. What will the WACCs be for each division? (Round your answers to 2 decimal places.)

Answer 1

Current Cost of Equity = 14%
Current Average Beta = 1
Risk Free Rate = 7%
After Tax Cost of Debt = 9%

As per CAPM Model, Cost of Equity is given by -

Where,
= Cost of Equity
= Risk Free Interest Rate
= Return on Market Portfolio
= Beta of the asset/equity

For, company's condition today, Cost of equity is given by -
14% = 7% + 1*( - 7%)
- 7% = 7%
= 14%

Now, let us check numbers for each division -
Division A, = 0.5
Division B, = 1.0
Division C, = 1.2
Division D, = 1.5
D/E Ratio for all divisions = 50/50 = 1
So, D/(D+E) = 50/(50+50) = 1/2 = 0.5
E/(D+E) = 50/(50+50) = 1/2 = 0.4

WACC is given by -

Where,
WACC = Weighted Avg Cost of Capital
D = Amount of Debt
E = Amount of Equity
Kd = Pre-tax cost of debt
t = tax rate
Kd*(1-t) = after-tax cost of debt
Ke = cost of equity

WACC for Division A:
Cost of Equity for division A is given by -


= 10.5%

WACC is given by -


WACC = 0.045 + 0.0525 = 0.0975 = 9.75%

WACC for Division B:
Cost of Equity for division A is given by -


= 14%

WACC is given by -


WACC = 0.045 + 0.07 = 0.115 = 11.5%




WACC for Division C:
Cost of Equity for division A is given by -


= 15.4%

WACC is given by -


WACC = 0.045 + 0.077 = 0.122 = 12.2%

WACC for Division D:
Cost of Equity for division A is given by -


= 17.5%

WACC is given by -


WACC = 0.045 + 0.0875 = 0.1325 = 13.25%

Answer:
WACC for Division A: 9.75%
WACC for Division B: 11.5%
WACC for Division C: 12.2%
WACC for Division D: 13.25%