Question

Divisional Costs of Capital Newtown Propane currently has only a wholesale division and uses only equity capital; however, it is considering creating marketing and retail divisions. Its beta is currently 1.3. The marketing division is expected to have a beta of 1.9, because it will have more risk than the firm's wholesale division. The retail division is expected to have a beta of 0.8, because it will have less risk than the firm's wholesale division. The risk-free rate is 2.8%, and the market risk premium is 6.7%. Based on this information, fill in the missing cost of capital information below: Wholesale division Marketing division Retail division If 70% of Newtown Propane's total value ends up in the wholesale division, 20% in the marketing division, and 10% in the retail division, then its investors should require a return of

option for wholesale division - 11.51%, 5.60%,1.96%, 6.44%

option for Marketing division - 16.88%, 16.48%, 18.03%, 15.53%

option for retail division - 17.48%, 16.28%, 8.16%, 17.58%

option for 4 - 16.73%, 14.83%, 11.98%, 13.28%

Answer 1

Based on CAPM,

Expected return on security = Risk free rate + Beta * Market risk premium

For Wholesale division,

Expected return = 2.8% + 1.3 * 6.7% = 11.51%

For Marketing division,

Expected return = 2.8% + 1.9 * 6.7% = 15.53%

For Retail division,

Expected return = 2.8% + 0.8 * 6.7% = 8.16%

Required return would be the weighted average of the required return of individual divisions.

Required Return = 70% * 11.51% + 20% * 15.53% + 10% * 8.16% = 11.98%