Question

A firm's cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions Wizard Co. currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions. Its beta is currently 1.3. The risk-free rate is 4.4%, and the market-risk premium is 5.2% О 8.80% 4.4090 10.12% O 11.16% This means that the firm's real estate division will have a cost of capital of: The consulting division is expected to have a beta of 1.8, because it will be riskier than the firm's real estate division O О О 16.26% 13.76% 15.11% 14.71% This means that the firm's consulting division will have a cost of capital of: The distribution division will have less risk than the firm's real estate division, so its beta is expected to be 0.8 О 14.51% 15.81% o 8.56% O 15.71% This means that the distribution division's cost of capital will be: Wizard Co. expects 70% of its total value to end up in the real estate division, 20% in the consulting division, and 10% in the distribution division 12.72% О 14.27% O 11.42% О 16.17% Based on this information, what rate of return should its investors require once it opens the new divisions?

Answer 1

Answer a.

Cost of Capital = Risk-free Rate + Beta * Market Risk Premium
Cost of Capital = 4.40% + 1.30 * 5.20%
Cost of Capital = 11.16%

Answer b.

Cost of Capital = Risk-free Rate + Beta * Market Risk Premium
Cost of Capital = 4.40% + 1.80 * 5.20%
Cost of Capital = 13.76%

Answer c.

Cost of Capital = Risk-free Rate + Beta * Market Risk Premium
Cost of Capital = 4.40% + 0.80 * 5.20%
Cost of Capital = 8.56%

Answer d.

Required Return = Weight of Real Estate Division * Cost of Capital of Real Estate Division + Weight of Consulting Division * Cost of Capital of Consulting Division + Weight of Distribution Division * Cost of Capital of Distribution Division
Required Return = 70% * 11.16% + 20% * 13.76% + 10% * 8.56%
Required Return = 11.42%