Homework Answers
a) First, we will calculate cost of capital of both the divisions,
Soft drink division
Cost of Capital = Risk free rate + Beta x Market Risk Premium
Cost of Capital = 2% + 0.51 x 5% = 4.55%
Chemical division
Cost of Capital = Risk free rate + Beta x Market Risk Premium
Cost of Capital = 2% + 1.13 x 5% = 7.65%
Value of Soft Drink division = Free cash Flow / (cost of capital - growth rate)
Value of Soft Drink division = $77 million /(4.55% - 3%) = $4,967.74 million
Value of Chemical division = Free cash Flow / (cost of capital - growth rate)
Value of Chemical division = $63 million /(7.65% - 2%) = $1,115.04 million
b)
Total value of firm = (4,967.74 + 1,115.04) Million
Total value of firm = $6,082.78 million
Current equity beta = Beta soft x Value Soft/Total value + Beta Chemical x Value Chemical/ Total Value
Weston's Current equity beta = 0.51 x $4,967.74/$6,082.78 + 1.13 x $1,115.04/$6,082.78
Weston's Current equity beta = 0.416 + 0.207 = 0.62 (approx)
c)Weston's cost of Capital
Cost of Capital = Risk free rate + Beta x Market Risk Premium
Weston's Cost of Capital = 2% + .62 x 5% = 5.12%(approx)
Its not useful because individual divisions are either less risky or more risky. The company's equity beta will decline towards 0.51 as the soft drink division has a higher growth rate and will be representing a larger fraction of the firm.
An upvote would be appreciated.
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