Question

5 pts Assume that your firm consists of Division 1 (40 percent of the firm) and Division 2 (60 percent of the firm). The capital structure for each of the divisions is the same as for the firm as a whole: 20.0 percent debt, at a before-tax cost of debt of 6.0 percent, and 80.0 percent equity (ie, D/E -0.25). Also assume that the firm calculates the cost of equity for each division using a divisional beta, where Division 1 has an unlevered beta of 1.20, while Division 2 has an unlevered beta of 1.50. Finally assume that the risk-free rate is 4.0 percent and the expected return on the market is 12.0 percent. and the firm's tax rate is 40%. Given this information, determine the difference between the WACC for Division 1 and the WACC for Division 2. Answer in decimal format, rounded to 4 decimal places. For example, if your answer is 1.334%, enter "0.0133".

Answer 1

Division 1

WACC for division 1 = kd * Wd*(1-t) + Ke * We

where kd is the cost of debt and ke is the cost of equity

Wd is the proportion of debt and We is the proportion of equity

Ke , Cost of equity = Risk free rate + Beta * Market risk premium

Unlevered beta = 1.2

Levered Beta = Unlevered beta*(1+D/E*(1-t)) = 1.2 *(1+0.25*0.6) =1.38

Cost of equity = 4% + 1.38*(12%-4%) = 15.04%

WACC = 6%*0.2*0.6 + 15.04% * 0.8 = 12.752%

Division 2

Unlevered Beta = 1.50

Levered Beta = 1.5*(1+ 0.25*0.6) = 1.725

Cost of equity = 4% + 1.725* 8% = 17.8%

WACC = 6%*0.2*0.6 + 17.8%* 0.8 = 14.96%

Difference in WACC = 14.96% - 12.752% = 2.208% = 0.0208