Answer:
Division 1's WACC - Division 2's WACC = 11.752% - 14.6656% = - 1.9136% or Division 1 has the lower cost of capital of 1.9136% in absolute term comparing to Division 2.
Explanation:
Before starting, we need to convert unlevered beta into levered beta:
Levered beta of Division 1: 1.2 x ( 1 + (1-40%) x 0.25) = 1.38
Leverage beta of Division 2: 1.46 x ( 1+ (1-40%) x 0.25) = 1.679
Then, we start step by step as below:
First, using the CAPM model: Cost of equity = risk-free rate of return + beta *(Market Rate of Return – Risk-free Rate of Return) , we find the cost of equity for Division 1 and Division 2.
- Division 1's cost of Equity = 4% + 1.38 x( 12% -4%) = 15.04%
- Division 2's cost of equity = 4% + 1.46 x (12% - 4%) = 17.432%
Second, determine the post-tax cost of debt applied for both Division: 6% x (1-tax rate) = 6% x (1 -40%) = 3.60%
Third, calculate the WACC for each Division:
- Division 1's WACC = % of debt in capital structure x cost of debt + % of equity in capital structure x cost of equity = 20% x 3.6% + 80% x 15.04% = 11.752%;
- Division 2's WACC = % of debt in capital structure x cost of debt + % of equity in capital structure x cost of equity = 20% x 3.6% + 80% x 17.432% = 14.6656%;
Finally, compare the WACC between the two Division:
Division 1's WACC - Division 2's WACC = 11.752% - 14.6656% = - 1.9136% or Division 1 has the lower cost of capital of 1.9136% in absolute term comparing to Division 2.
