Question

Your company has two divisions: One division sells software and the other division sells computers through a direct sales channel, primarily taking orders over the internet. You have decided that Dell Computer is very similar to your computer division, in terms of both risk and financing. You go online and find the following information: Dell's beta is 1.18, the risk-free rate is 4.9%, its market value of equity is $65.3 billion, and it has $703 million worth of debt with a yield to maturity of 6.4%. Your tax rate is 40% and you use a market risk premium of 5.5% in your WACC estimates. a. What is an estimate of the WACC for your computer sales division? b. If your overall company WACC is 11.7% and the computer sales division represents 45% of the value of your firm, what is an estimate of the WACC for your software division? Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

a). According to CAPM,

Cost of Equity(kE) = rF + [Beta * Market Risk Premium]

= 4.9% + [1.18 * 5.5%] = 4.9% + 6.49% = 11.39%

WACC = [wD * kD * (1 - t)] + [wE * kE]

= [{703 / (65,300 + 703)} * 6.4% * (1 - 0.40)] + [{65,300 / (65,300 + 703)} * 11.39%]

= 0.04% + 11.27% = 11.31%

b). WACC = [w(Computer Division) * k(Computer Division)] + [w(Software Division) * k(Software Division)]

11.7% = [0.45 * 11.31%] + [(1 - 0.45) * k(Software Division)]

11.7% = 5.09% + [0.55 * k(Software Division)]

11.7% - 5.09% = 0.55 * k(Software Division)

k(Software Division) = 6.61% / 0.55 = 12.02%