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 1.18?, the? risk-free rate is 4.2 %?, its market value of equity is $ 67.3 ?billion, and it has $ 708 million worth of debt with a yield to maturity of 6.5 %. Your tax rate is 38 % and you use a market risk premium of 5.8 % in your WACC estimates.

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

b. If your overall company WACC is 11.6 % and the computer sales division represents 44 % of the value of your? firm, what is an estimate of the WACC for your software? division?

(round to two decimal places)

Answer 1

solution :

Since Dell computer has similar risk and financing as computer division for our company so we can use the data for dell to compute the WACC for computer division.

Dell:

Risk- free rate = 4.2%, beta = 1.18, Market risk premium = 5.8%

Cost of equity = Risk-free rate + beta * Market Risk premium = 4.2% + 1.18 * 5.8% = 11.044%

Since yield to maturity is given as 6.5% and this is pretax cost of debt for the company and

After tax Cost of debt = Yield to maturity * (1- tax) = 6.5% * (1-0.38) = 4.03%

Debt = $708 million , Equity = $ 67.3 ?billion,

Debt weight = Debt/ (Debt + Equity ) = 708 million/(708 million +67.3B billion )= 708/(708+67,300) = 0.01

Equity Weight = 1- debt weight = 1-0.01 = 0.99

WACC = cost of debt * weight of debt + cost of equity * weight of equity

= 4.03% * 0.01 + 11.044% * 0.99 = 10.97%

Part A ) So WACC of computer sales divison is 10.97%

Part B ) WACC (overall of the company) = 11.6%

So overall WACC consists of 44% * WACC of computer sales division and 56% (1-0.44) * WACC of software division

So we can say that

11.6% = 10.97% * 0.44 + 0.56 * WACC of software Division

0.56 * WACC of software Division = 11.6% - 4.8268% = 6.7732%

WACC of software division = 6.7732% / 0.56 = 12.095% = 12.10%