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 4.6%​, its market value of equity is $66.6 billion, and it has $709 million worth of debt with a yield to maturity of 5.7% Your tax rate is 40% and you use a market risk premium of 5.3% 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 36% 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.

Answer 1

a

Total Capital value = Value of Debt + Value of Equity

=0.709+66.6

=67.309

Weight of Debt = Value of Debt/Total Capital Value

= 0.709/67.309

=0.0105

Weight of Equity = Value of Equity/Total Capital Value

= 66.6/67.309

=0.9895

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 4.6 + 1.18 * (5.3)

Cost of equity% = 10.85

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.7*(1-0.4)

= 3.42

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.42*0.0105+10.85*0.9895

WACC =10.77%

b

Weight of Comp sales div = 0.36

Weight of Software div = 0.64

Cost of Firm Capital = Weight of Comp sales div*Cost of Comp sales div+Weight of Software div*Cost of Software div

11.6 = 10.77*0.36+Cost of Software div*0.64

Cost of Software div = 12.067