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 0.8, 1.1, 1.5, and 1.7, respectively. Assume all current and future projects will be financed with 35 percent debt and 65 percent equity, the current cost of equity (based on an average firm beta of 1.3 and a current risk-free rate of 6 percent) is 15 percent and the after-tax yield on the company’s bonds is 11 percent. What will the WACCs be for each division? (Do not round intermediate calculations and round your final answers to 2 decimal places.) WACCs

Division A %

Division B %

Division C %

Division D %

Answer 1

Company:

Risk-free Rate = 6%
Beta = 1.3
Cost of Equity = 15%

Cost of Equity = Risk-free Rate + beta * Market risk premium
15% = 6% + 1.3 * Market risk premium
9% = 1.3 * Market risk premium
Market risk premium = 6.92%

Division A:

Market risk premium = 6.92%
Risk-free Rate = 6%
Beta = 0.8
After-tax Cost of Debt = 11%
Weight of Debt = 35%
Weight of Equity = 65%

Cost of Equity = Risk-free Rate + beta * Market risk premium
Cost of Equity = 6% + 0.8 * 6.92%
Cost of Equity = 11.536%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Equity* Cost of Equity
WACC = 35% * 11% + 65% * 11.536%
WACC = 11.35%

Division B:

Market risk premium = 6.92%
Risk-free Rate = 6%
Beta = 1.1
After-tax Cost of Debt = 11%
Weight of Debt = 35%
Weight of Equity = 65%

Cost of Equity = Risk-free Rate + beta * Market risk premium
Cost of Equity = 6% + 1.1 * 6.92%
Cost of Equity = 13.612%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Equity* Cost of Equity
WACC = 35% * 11% + 65% * 13.612%
WACC = 12.70%

Division C:

Market risk premium = 6.92%
Risk-free Rate = 6%
Beta = 1.5
After-tax Cost of Debt = 11%
Weight of Debt = 35%
Weight of Equity = 65%

Cost of Equity = Risk-free Rate + beta * Market risk premium
Cost of Equity = 6% + 1.5 * 6.92%
Cost of Equity = 16.38%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Equity* Cost of Equity
WACC = 35% * 11% + 65% * 16.38%
WACC = 14.50%

Division D:

Market risk premium = 6.92%
Risk-free Rate = 6%
Beta = 1.7
After-tax Cost of Debt = 11%
Weight of Debt = 35%
Weight of Equity = 65%

Cost of Equity = Risk-free Rate + beta * Market risk premium
Cost of Equity = 6% + 1.7 * 6.92%
Cost of Equity = 17.764%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Equity* Cost of Equity
WACC = 35% * 11% + 65% * 17.764%
WACC = 15.40%