Question

Your company has two​ divisions: One division sells software and the other division sells computers through a direct sales​ channel, primarily taking orders over the internet. You have decided that Dell Computer is very similar to your computer​ division, in terms of both risk and financing. You go online and find the following​ information: Dell's beta is 1.16​, the​ risk-free rate is 4.3 %​, its market value of equity is $ 67.7 ​billion, and it has $ 697 million worth of debt with a yield to maturity of 5.7 %. Your tax rate is 40 % and you use a market risk premium of 5.6 % in your WACC estimates. a. What is an estimate of the WACC for your computer sales​ division? b. If your overall company WACC is 12.7 % and the computer sales division represents 37 % of the value of your​ firm, what is an estimate of the WACC for your software​ division? ​Note: Assume that the firm will always be able to utilize its full interest tax shield. What is an estimate of the WACC for your computer sales​ division?

Answer 1

Answer:

a) 10.72%

b) 13.86%

Explanation:

Requirement a)

We know,

WACC = We*Ke + Wd*Kd (1 -T)

Here, We = Weights of equity

Wd = Weights of debt

Ke = Cost of equity

Kd (1 -T) = Cost of debt after tax

To find the We, Wd, we have to calculate the total value of the firm. Therefore,

Equity       $67,700,000,000

Debt               $697,000,000

Total          $68,397,000,000

Weights of Equity (We) = $67,700,000,000/$68,397,000,000 = 0.9898

Weights of Debt (Wd) = $697,000,000/$68,397,000,000 = 0.0102

To find the cost of equity (Ke), we have to use Capital pricing model (CAPM), Ke = Rf + (Rm - Rf)* B

Ke = 4.3% + 5.6%*1.16 = 10.796%

Now, putting all the values in WACC formula, we get

WACC for the computer sales division

= (0.9898*10.796%) + (0.0102*5.7%*(1-0.40)) = 10.72%

Requirement b)

Since we have to find a specific division's WACC, therefore, we have to calculate it from the overall company's WACC.

WACC for overall company =  (WACC of computer sales division x % of computer sales division) + (WACC of software division x % of software division)

Since, the value of sales division is 37%, the software division's value is = (100% - 37%) = 63%

12.7% = (10.72%*37%) + (WACC of software division x 63%)

12.7% = 3.9664% + (WACC of software division x 63%)

(WACC of software division x 63%) = 8.7336%

WACC of software division = 8.7336%/63% = 13.86%