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 1.21​, the​ risk-free rate is 4.5 %​, its market value of equity is $ 67.0 ​billion, and it has $ 700 million worth of debt with a yield to maturity of 6.0 %. Your tax rate is 25 % and you use a market risk premium of 5.0 % in your WACC estimates. a. What is an estimate of the WACC for your computer sales​ division? b. If your overall company WACC is 12.0 % and the computer sales division represents 40 % 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) Since the dell computer has similar risk and financing structure as Computer sales division, So WACC of Dell computers = WACC of Computer sales division

According to Capital Asset Pricing Model

Cost of equity of Dell computers = Risk free rate + Beta x Market risk premium = 4.5% + 1.21 x 5% = 4.5% + 6.05% = 10.55%

Cost of debt of Dell computers = Yield to maturity of debt = 6%

Total equity of Dell Computers = E = $67 billion = 67000 million and Total Debt of Dell computers = D = 700 million

Total value of Dell computers = V = E + D = 67000 + 700 = 67700 million

WACC of Dell computers = Cost of debt x (D/V) x (1-tax rate) + Cost of equity x (E/V) = 6% x (700/67700) x (1-25%) + 10.05% x (67000 /(67700) = 6% x (700/67700) x (75%) + 10.05% x (67000 /(67700) = 0.000465 + 0.104409 = 0.0465% +10.4409% = 10.4874%

Now WACC of Dell computers = WACC of Computer sales division = 10.4874%

So WACC of computer sales division = 10.4874%

b) Weight of computer sales division = 40% and Weight of Software division = 1 - Weight of computer sales division = 1 - 40% = 60%

WACC of firm = 12% = Weight of computer sales division x WACC of computer sales division + Weight of Software division x WACC of software division

12% = 40% x 10.4874% + 60% x WACC of software division

12% = 4.1949% + 60% x WACC of software division

7.8051% = 60% x WACC of software division

WACC of software division = 7.8051% / 60% = 0.130085 = 13.0085%

Hence WACC of software division = 13.0085%