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 0.6, 1.0, 1.3, and 1.6, respectively. Assume all current and future projects will be financed with 60 debt and 40 equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 5 percent) is 12 percent and the after-tax yield on the company’s bonds is 8 percent.

What will the WACCs be for each division?

Answer 1

WACC of the various divisions are as follows:-

A = .0848 or 8.48%

B = .96 or 9.6%

C = .1044 or 10.44%

D =  .1128 or 11.28%

CALCULATIONS

Step 1:- calculation of market rate of return:

Using CAPM model:

Cost of equity (Ke) = Rf + β(Rm-Rf )

12% = 5% + 1 *(Rm- 5%)

Rm = 12%

Step 2:- calculation of cost of equity

Using CAPM model:

1. Division A

Cost of equity (Ke) = Rf + β(Rm-Rf )

Cost of equity (Ke) = 5% + .6 (12% - 5% )

Cost of equity (Ke) = 5% + 4.2%

Cost of equity (Ke) = 9.2%

2. Division B

Cost of equity (Ke) = Rf + β(Rm-Rf )

Cost of equity (Ke) = 5% + 1*(12% - 5% )

Cost of equity (Ke) = 5% + 7%

Cost of equity (Ke) = 12%

3. Division C

Cost of equity (Ke) = Rf + β(Rm-Rf )

Cost of equity (Ke) = 5% + 1.3*(12% - 5% )

Cost of equity (Ke) = 5% + 9.1%

Cost of equity (Ke) = 14.1%

4. Division D

Cost of equity (Ke) = Rf + β(Rm-Rf )

Cost of equity (Ke) = 5% + 1.6*(12% - 5% )

Cost of equity (Ke) = 5% + 11.2%

Cost of equity (Ke) = 16.2%

Step 3:- WACC calculation

=(weight of debt * cost of debt) + (weight of equity * cost of equity)

Weight of bond = .6

Weight of equity = .4

After tax cost of bond = 8%

1. Division A

= (.6*.4) + (.4*.092)

= .048 +.0368

= .0848 or 8.48%

2. Division B

= (.6*.4) + (.4*.12)

= .048 + .48

= .96 or 9.6%

3. Division C

= (.6*.4) + (.4*.141)

= .048 + .0564

= .1044 or 10.44%

4. Division D

= (.6*.4) + (.4* .162)

= .048 + .0648

= .1128 or 11.28%