Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has 2 divisions, A and B, with betas for each division of 1.25 and 2.5, respectively. If all current and future projects will be financed with half debt and half equity, and if the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 4 percent) is 12 percent and the after-tax yield on the company's bonds is 8 percent, what are the WACCs for divisions A and B?
A) 11.00 percent; 16.00 percent
B) 15.00 percent; 30.00 percent
C) 25.00 percent; 30.00 percent
D) 20.00 percent; 34.00 percent

Question

Quizplus · Accepted Answer

The WACC for each division can be calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V is the total value (E + D), Re is the cost of equity, Rd is the after-tax cost of debt, and Tc is the corporate tax rate. Given that the financing is half debt and half equity, E/V and D/V both equal 0.5. The cost of equity (Re) for each division can be adjusted based on their betas using the CAPM model: Re = Rf + Beta*(Market Risk Premium), where Rf is the risk-free rate and the Market Risk Premium can be calculated as the difference between the current cost of equity (12%) and the risk-free rate (4%), which is 8%. For Division A, Re = 4% + 1.25*8% = 14%. For Division B, Re = 4% + 2.5*8% = 24%. The after-tax cost of debt (Rd) is given as 8%. Therefore, WACC for Division A = 0.5*14% + 0.5*8% = 11%, and for Division B = 0.5*24% + 0.5*8% = 16%.

Suppose Your Firm Has Decided to Use a Divisional WACC