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 1.16​, the​ risk-free rate is 4.1 %​, its market value of equity is $ 65.5 ​billion, and it has $ 700 million worth of debt with a yield to maturity of 6.4 %. Your tax rate is 40 % and you use a market risk premium of 5.2 % 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? ​Note: Assume that the firm will always be able to utilize its full interest tax shield. a. What is an estimate of the WACC for your computer sales​ division? The weighted average cost of capital for your computer sales division is nothing​%

Answer 1

Answer :

(a.) Calculation of WACC of Computer's Division:

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Equity * Weight of Equity)

Given Equity = 65,500,000,000

Debt = 700,000,000

Total Market Value = 65,500,000,000 + 700,000,000 = 66,200,000,000

Calculation of Weight of Equity

Weight of Equity = Equity Value / Total Market Value

= 65,500,000,000 / 66,200,000,000

= 0.98942598187 or 0.9894

Weight of Debt = Debt Value / Total Market Value

  = 700,000,000 / 66,200,000,000

= 0.01057401812 or 0.0106

Cost of Equity = Risk free rate + Beta * Market Risk Premium

= 4.1% + (1.16 * 5.2%)

= 10.132%

Cost of Debt after Tax = Yield to maturity * (1 - Tax rate)

= 6.4 % * (1 - 0.40)

= 3.84%

WACC = (3.84% * 0.01057401812) + ( 10.132% * 0.98942598187)

= 0.0406% + 10.0249%

= 10.065% or 10.07%

(b.) Calculation of WACC of software division :

Given Overall WACC = 11.6%

WACC of Computer division (calculated in part a.) = 10.07%

Weight of Computer Division = 44% or 0.44

Weight of software division = 100% - 44% = 56% or 0.56

11.6% = (10.065% * 0.44 ) + (WACC of software division * 0.56)

11.6 % = 4.4286% + (WACC of software division * 0.56)

7.1714% = WACC of software division * 0.56

==> WACC of software division = 7.1714 / 0.56

= 12.806% or 12.81%