Question

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 1.1. The marketing division is expected to have a beta of 2.1, 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 4.4%, and the market-risk premium is 6.4%. Based on this information, fill in the missing information in the following below: Cost of Capital Wholesale division Marketing division Retail division IF 55% of Newtown Propane's total value ends up in the wholesale division, 20% in the marketing division, and 25% in the retail division, then its investors should require a return of

Answer 1

As per CAPM, cost of capital = Risk free return + beta*market risk premium

Wholesale Division = 4.4% + 1.1*6.4%

= 11.44%

Marketing = 4.4% + 2.1*6.4%

= 17.84%

Retail = 4.4% + 0.8*6.4%

= 9.52%

Portfolio Return is equal to weighted average return

= 11.44%*0.55 + 17.84%*0.20 + 9.52%*0.25

= 12.24%