Question

Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions A throughb D with average betas for each division of 0.8 1.2 1.4 and 1.6 respectively. Assume all current and future projects will be financed with 20 percent debt and 80 percent equity the current cost of equity firm beta of 1.1 and a current risk free rate of 7 is 11 percent and the after tax yoeld on the companys bonds is 12 percent.

Answer 1

Calculation of WACC for all divisions:

WACC of division A is 10.33%

WACC of division B is 11.49%

WACC of division C is 12.07%

WACC of division D is 12.66%

Given in Question,

Current cost of equity = 11%

Beta = 1.1

Risk free rate = 7%

After tax yield on bond (K _d)= 12%

Now from the above given figures we can calculate market rate of return by applying following equation,

As per CAPM,

K _e= R _f + $\beta$ (R _m - R _f)

Where,

K _e = Cost of equity

R _f = Risk free rate

$\beta$ = Beta

R _m = Market rate of return

By applying the above formula we get,

11% = 7% + 1.1(R _m - 7%)

(R _m - 7%) = (11% - 7%) / 1.1

R _m = 10.63636%

Now calculate cost of equity for all 4 divisions:

Division	Beta	R f	R m	K e= R f + $\beta$ (R m - R f)
A	0.8	7%	10.63636%	9.91%
B	1.2	7%	10.63636%	11.36%
C	1.4	7%	10.63636%	12.09%
D	1.6	7%	10.63636%	12.82%

Calculate WACC

Division	K e	K d	WACC = .80*K e +.20*K d
A	9.91%	12%	10.33%
B	11.36%	12%	11.49%
C	12.09%	12%	12.07%
D	12.82%	12%	12.66%

As projects will be financed with 20% debt and 80% equity, hence the WACC is calculated accordingly.