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 1.4. The marketing division is expected to have a beta of 1.8, because it will have more risk than the firm's wholesal 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 3.1%, and the market risk premium is 5.2%. Based on this information, fill in the missing cost of capital information below: Wholesale division Marketing division Retail division If 75% of Newtown Propane's total value ends up in the wholesale division, 10% in the marketing division, and 15% in the retail division, then its investors should require a return of

Answer 1

As per Capital Asset Pricing Model [CAPM], The Cost of Capital shall be computed by using the following equation

Cost of Capital = Risk-free Rate + [Beta x Market Risk Premium]

Cost of Capital – Wholesale Division

Cost of Capital = Risk-free Rate + [Beta x Market Risk Premium]

= 3.10% + [1.40 x 5.20%]

= 3.10% + 7.28%

= 10.38%

Cost of Capital – Marketing Division

Cost of Capital = Risk-free Rate + [Beta x Market Risk Premium]

= 3.10% + [1.80 x 5.20%]

= 3.10% + 9.36%

= 12.46%

Cost of Capital – Retail Division

Cost of Capital = Risk-free Rate + [Beta x Market Risk Premium]

= 3.10% + [0.40 x 5.20%]

= 3.10% + 2.08%

= 5.18%

Required Rate of Return

Required Rate of Return = Sum[Returns x Investment Proportion]

= [10.38% x 0.75] + [12.46% x 0.10] + [5.18% x 0.15]

= 7.79% + 1.25% + 0.78%

= 9.81%

“If 75% of Newtown Propane’s total Value ends up in wholesale division, 10% in the marketing division, and 15% in the retail division, then it’s investors should require a return of 9.81%”