Branson works for a firm that is expanding into a completely new line of business.He has been asked to determine an appropriate WACC for an average-risk project in the expansion division.Branson finds two publicly traded stand-alone firms that produce the same products as his new division.The average of the two firm's betas is 1.40.Further,he determines that the expected return on the market portfolio is 11.00% and the risk-free rate of return is 3.00%.Branson's firm finances 70% of its projects with equity and 30% with debt,and has a before-tax cost of debt of 8% and a corporate tax rate of 20%.What is the WACC for the new line of business?
A)About 12.64%
B)About 13.12%
C)About 10.78%
D)About 11.86%

Question

Quizplus · Accepted Answer

To calculate the Weighted Average Cost of Capital (WACC) for the new line of business, we use 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 = E + D (the total market value of the firm's financing), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate.First, calculate the cost of equity (Re) using the Capital Asset Pricing Model (CAPM): Re = Rf + β(Rm - Rf), where Rf is the risk-free rate, β is the beta of the stock, and Rm is the expected return on the market. Substituting the given values: Re = 3% + 1.40(11% - 3%) = 3% + 1.40(8%) = 3% + 11.2% = 14.2%.Next, calculate the after-tax cost of debt (Rd*(1-Tc)): 8% * (1 - 0.20) = 8% * 0.80 = 6.4%.Finally, calculate the WACC using the given weights for equity (70%) and debt (30%): WACC = (0.70 * 14.2%) + (0.30 * 6.4%) = 9.94% + 1.92% = 11.86%.

Branson Works for a Firm That Is Expanding into a Completely