Question

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 1.1. 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 4.8%, and the market-risk premium is 6.1%. Based on this information, fill in the missing information in the following below: Cost of Capital 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

Answer 1

Based on CAPM,

Cost of security = Risk free rate + Beta * market risk premium

For Wholesale division

Cost of capital = 4.8% + 1.1 * 6.1%

Cost of capital = 11.51%

For Marketing division,

Cost of capital = 4.8% + 1.9 * 6.1%

Cost of capital = 16.39%

For Retail division,

Cost of capital = 4.8% + 0.8 * 6.1%

Cost of capital = 9.68%

Expected return for the firm would be weighted average of the cost of individual division's capital.

Required return = 70% * 11.51%  + 20% * 16.39% + 10% * 9.68% = 12.30%