Question

A company is going to open a new division. The division will be financed with $1 million in debt and $3 million in equity. The tax rate is 15% for all firms. The risk-free rate is 1% and market portfolio return is 7%. The yield on the division’s debt is 4%. The information on the relevant pure play companies is given below:

pure play firm	beta	debt/equity
A	1.5	0.6
B	0.8	0.2

1. What is the project beta of the pure play firm A?
2. What is the project beta of the pure play firm B?
3. What is the average of the project betas of the pure play firms?
4. What is the new division’s beta?
5. What is the cost of equity of the new division?
6. What is the new division’s WACC?

Answer 1

a) Project beta for A = Beta /(1+Debt/Equity) = 1.5/(1+0.6) = 0.9375

b) Project beta for B = Beta /(1+Debt/Equity) = 0.8/(1+0.2) = 0.67

c) Average of project beta = (Project beta of A + Project beta of B)/2

= (0.9375+0.67) /2 =0.80

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