Question

7. Adjusting the cost of capital for risk Aa Aa 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 2.0, because it will have more risk than the firm's wholesale division. The retail division is expected to have a beta of 0.4, because it will have less risk than the firm's wholesale division. The risk-free rate is 3.6%, and the market-risk premium is 5.8%. Based on this information, fill in the missing information in the following below: Cost of Capital Wholesale division Marketing division Retail division If 60% of Newtown Propane's total value ends up in the wholesale division, 25% in the marketing division, and 15% in the retail division, then its investors should require a return of

Answer 1

Wholesale division

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 3.6 + 1.3 * (5.8)

Expected return% = 11.14

Marketing division

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 3.6 + 2 * (5.8)

Expected return% = 15.2

Retail division

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 3.6 + 0.4 * (5.8)

Expected return% = 5.92

Expected return

Weight of Wholesale = 0.6

Weight of Marketing = 0.25

Weight of Retail = 0.15

Return of Firm = Weight of Wholesale*Return of Wholesale+Weight of Marketing*Return of Marketing+Weight of Retail*Return of Retail

Return of Firm = 11.14*0.6+15.2*0.25+5.92*0.15

Return of Firm = 11.372