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 0.6, 1.0, 1.3, and 1.6, respectively. Assume all current and future projects will be financed with half debt and half equity, the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 3 percent) is 14 percent and the after-tax yield on the company’s bonds is 8 percent.

What will the WACCs be for each division? (Round your answers to 2 decimal places.)

WACCs
a. Division A %
b. Division B %
c. Division C %
d. Division D %

Answer 1

The WACCs be for each division would be the following:

a. Division A 8.8 %

b. Division B 11%

c. Division C 12.65%

d. Division D 14.3%

Step-by-step explanation:

In order to calculate the WACCs be for each division first we need to calculate the cost of equity for each division and the Firm's cost of equity as follows:

Firm's cost of equity = risk free rate + beta * market risk premium

Hence, 14% = 3% + 1.0 * market risk premium

market risk premium = 11%

Cost of equity for A = 3% + 0.6*11% = 9.6%

Cost of equity for B = 3% + 1.0*11% = 14%

Cost of equity for C = 3% + 1.3*11% = 17.3%

Cost of equity for D = 3% + 1.6*11% = 20.6%

Therefore, the WACCs be for each division would be the following:

WACC for A = 0.50 * 8% + 0.50 * 9.6% = 8.8%

WACC for B = 0.50 * 8% + 0.50 * 14% = 11%

WACC for C = 0.50 * 8% + 0.50 * 17.3% = 12.65%

WACC for D = 0.50 * 8% + 0.50 *20.6% = 14.3%